China Traditional Chinese Medicine Holdings Co. Limited (HKG:570) shareholders would be excited to see that the share price has had a great month, posting a 47% gain and recovering from prior weakness. While recent buyers may be laughing, long-term holders might not be as pleased since the recent gain only brings the stock back to where it started a year ago.

After such a large jump in price, China Traditional Chinese Medicine Holdings' price-to-earnings (or "P/E") ratio of 21.2x might make it look like a strong sell right now compared to the market in Hong Kong, where around half of the companies have P/E ratios below 8x and even P/E's below 4x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

With earnings that are retreating more than the market's of late, China Traditional Chinese Medicine Holdings has been very sluggish. One possibility is that the P/E is high because investors think the company will turn things around completely and accelerate past most others in the market. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Does Growth Match The High P/E?

China Traditional Chinese Medicine Holdings' P/E ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the market.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 34%. As a result, earnings from three years ago have also fallen 36% overall. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Shifting to the future, estimates from the five analysts covering the company suggest earnings should grow by 23% per year over the next three years. Meanwhile, the rest of the market is forecast to only expand by 15% each year, which is noticeably less attractive.

In light of this, it's understandable that China Traditional Chinese Medicine Holdings' P/E sits above the majority of other companies. Apparently shareholders aren't keen to offload something that is potentially eyeing a more prosperous future.

The Key Takeaway

The strong share price surge has got China Traditional Chinese Medicine Holdings' P/E rushing to great heights as well. Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.

As we suspected, our examination of China Traditional Chinese Medicine Holdings' analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. It's hard to see the share price falling strongly in the near future under these circumstances.

Don't forget that there may be other risks. For instance, we've identified 2 warning signs for China Traditional Chinese Medicine Holdings that you should be aware of.

If you're unsure about the strength of China Traditional Chinese Medicine Holdings' business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.