The Guangdong Shirongzhaoye Co., Ltd. (SZSE:002016) share price has done very well over the last month, posting an excellent gain of 26%. The bad news is that even after the stocks recovery in the last 30 days, shareholders are still underwater by about 2.2% over the last year.

Following the firm bounce in price, given around half the companies in China have price-to-earnings ratios (or "P/E's") below 31x, you may consider Guangdong Shirongzhaoye as a stock to potentially avoid with its 35.1x P/E ratio. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

The earnings growth achieved at Guangdong Shirongzhaoye over the last year would be more than acceptable for most companies. It might be that many expect the respectable earnings performance to beat most other companies over the coming period, which has increased investors' willingness to pay up for the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Does Growth Match The High P/E?

There's an inherent assumption that a company should outperform the market for P/E ratios like Guangdong Shirongzhaoye's to be considered reasonable.

Taking a look back first, we see that the company managed to grow earnings per share by a handy 9.8% last year. Ultimately though, it couldn't turn around the poor performance of the prior period, with EPS shrinking 80% in total over the last three years. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Weighing that medium-term earnings trajectory against the broader market's one-year forecast for expansion of 38% shows it's an unpleasant look.

In light of this, it's alarming that Guangdong Shirongzhaoye's P/E sits above the majority of other companies. It seems most investors are ignoring the recent poor growth rate and are hoping for a turnaround in the company's business prospects. Only the boldest would assume these prices are sustainable as a continuation of recent earnings trends is likely to weigh heavily on the share price eventually.

The Final Word

The large bounce in Guangdong Shirongzhaoye's shares has lifted the company's P/E to a fairly high level. It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

Our examination of Guangdong Shirongzhaoye revealed its shrinking earnings over the medium-term aren't impacting its high P/E anywhere near as much as we would have predicted, given the market is set to grow. Right now we are increasingly uncomfortable with the high P/E as this earnings performance is highly unlikely to support such positive sentiment for long. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 3 warning signs with Guangdong Shirongzhaoye (at least 2 which are a bit unpleasant), and understanding these should be part of your investment process.

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

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.