Why IQE plc could fall by 25%+

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IQE(LSE: IQE) has enjoyed a stunning year. The designer and manufacturer of advanced semiconductor wafer products has recorded a share price rise of over 400% during the period. This has led to increasing optimism among many investors, with calls for a higher valuation based on significant growth potential over the long run. While this may be possible, the company's valuation now suggests that its share price could experience a fall of 25% or more over the medium term.

A growing industry

The company's products are likely to gain in popularity over the long run. Its advanced semiconductor wafer products form a key part of the manufacturing process in the global semiconductor industry, with their use becoming more prevalent in a wide range of applications. With the Internet of Things industry continuing to grow, there is clear opportunity for IQE to deliver double-digit earnings growth on a regular basis.

With it having a competitive advantage over a number of other companies operating in the same segment, it could be at the forefront of a major growth area over the long run. This could lead to earnings upgrades (as was recently the case in its trading update), which may allow it to grow its bottom line at a faster pace than the 2% rate which is forecast in the 2017 financial year.

Valuation

While the outlook for IQE from a business perspective is positive, its investment potential appears to be less encouraging. While it has deserved to rise significantly in the last year, the prospect of further gains in future appears to be relatively limited.

That's partly because it now trades on a price-to-earnings (P/E) ratio of around 33. This is significantly higher than its average P/E ratio of around 11.5 during the last five years. And with it growing its earnings at an annualised rate of 21% in the last four years, it was much easier to justify a rapidly-rising rating in the past.

The potential for a share price fall is increased as a result of its valuation being overly optimistic given its medium-term outlook. As mentioned, it is due to grow earnings by 2% this year. It is expected to follow this up with growth of 17% next year. Combining next year's figure with its P/E ratio equates to a price-to-earnings growth (PEG) ratio of around 2. This appears to be excessive and could prompt a share price fall of 25% in order to reduce its PEG ratio to a more attractive 1.5.

Looking ahead

Clearly, investors are happy to pay a high price for future growth potential. And with IQE having a bright outlook, it is unsurprising that it has risen sharply in the last year. However, it started off with a low valuation at a time when it was delivering high earnings growth. Today, it may still have the potential to do the latter, but its rating now suggests that a share price fall could be on the cards.

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Peter Stephens has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes