Hangzhou First Applied Material Co., Ltd. (SHSE:603806) shareholders have had their patience rewarded with a 27% share price jump in the last month. Unfortunately, the gains of the last month did little to right the losses of the last year with the stock still down 41% over that time.

Following the firm bounce in price, given around half the companies in China have price-to-earnings ratios (or "P/E's") below 28x, you may consider Hangzhou First Applied Material as a stock to potentially avoid with its 35.1x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

Recent times haven't been advantageous for Hangzhou First Applied Material as its earnings have been falling quicker than most other companies. 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.

What Are Growth Metrics Telling Us About The High P/E?

In order to justify its P/E ratio, Hangzhou First Applied Material would need to produce impressive growth in excess of the market.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 38%. That put a dampener on the good run it was having over the longer-term as its three-year EPS growth is still a noteworthy 12% in total. So we can start by confirming that the company has generally done a good job of growing earnings over that time, even though it had some hiccups along the way.

Turning to the outlook, the next three years should generate growth of 37% each year as estimated by the analysts watching the company. That's shaping up to be materially higher than the 22% each year growth forecast for the broader market.

With this information, we can see why Hangzhou First Applied Material is trading at such a high P/E compared to the market. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Final Word

Hangzhou First Applied Material shares have received a push in the right direction, but its P/E is elevated too. Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

We've established that Hangzhou First Applied Material maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. 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.

You should always think about risks. Case in point, we've spotted 2 warning signs for Hangzhou First Applied Material you should be aware of, and 1 of them is concerning.

Of course, you might also be able to find a better stock than Hangzhou First Applied Material. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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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.