Why I think this FTSE 250 stock looks overvalued and ready to slump

While it is important for a company to deliver improved financial performance, there is much more to investing than picking stocks with growing profitability. In fact, in many cases a company’s future prospects may be priced-in to its valuation. Therefore, new investors may not enjoy significant upside over the medium term. Reporting on Thursday was a company which appears to neatly fit into that category.

Improving performance

The company in question is industrial engineering specialist Spirax-Sarco (LSE: SPX). Its financial performance in 2016 represented a significant step up from its 2015 numbers. For example, revenue increased by 14% and adjusted operating profit was 18% higher. The latter benefitted from an increased operating margin, with it rising by 100 basis points. This allowed the company to increase dividends by 10% and with cash conversion of 101%, 2016 was an excellent year for the business.

This came at a time when the company’s operating conditions were challenging. Global industrial production was low in 2016, and Spirax-Sarco was generally able to outperform its markets. Its investment in improving margins and delivering robust organic growth of 4% proved to be a sensible strategy to pursue. As such, it seems to be well-positioned to deliver higher growth in future years.

Investment potential

In 2017, Spirax-Sarco is expected to record a rise in earnings of 10%, followed by further growth of 6% next year. While this rate of growth is slightly higher than the expected growth rate of the wider index, it does not indicate a particularly strong performance lies ahead for the company.

Despite this, its shares trade on a premium valuation. They have a price-to-earnings (P/E) ratio of 26.8, which is in excess of their four-year average P/E ratio of 21.6. Therefore, there seems to be scope for a major derating of Spirax-Sarco’s shares over the medium term. If their P/E ratio reverts to the long-term average then a share price fall in the high single-digits could be on the cards. That’s assuming the company is able to continue to outperform the wider global industrial production sector, which is not guaranteed.

Higher growth potential

Within the same industry as Spirax-Sarco is specialist engineering company IMI (LSE: IMI). It is forecast to record a rise in earnings of just 1% this year, but is due to follow that up with growth of 12% next year. As well as offering superior growth potential than its sector peer, IMI trades on a lower valuation. It has a P/E ratio of 20.2. When combined with its forecast growth rate, this equates to a price-to-earnings growth (PEG) ratio of just 1.7. This compares to a PEG ratio of around 3.3 for its sector peer.

Clearly, the industrial sector is an uncertain industry in which to invest at the present time. Both Spirax-Sarco and IMI seem to be performing better than their wider industries, which is encouraging for their investors. However, since the latter offers a significantly lower valuation than the former, it seems to be the only one of the two companies worthy of investment at the present time.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has recommended IMI. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.