Shenzhen iN-Cube Automation Co., Ltd.'s (SZSE:301312) price-to-earnings (or "P/E") ratio of 65.1x might make it look like a strong sell right now compared to the market in China, where around half of the companies have P/E ratios below 34x and even P/E's below 19x 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.

As an illustration, earnings have deteriorated at Shenzhen iN-Cube Automation over the last year, which is not ideal at all. It might be that many expect the company to still outplay most other companies over the coming period, which has kept the P/E from collapsing. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Is There Enough Growth For Shenzhen iN-Cube Automation?

The only time you'd be truly comfortable seeing a P/E as steep as Shenzhen iN-Cube Automation's is when the company's growth is on track to outshine the market decidedly.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 17%. This means it has also seen a slide in earnings over the longer-term as EPS is down 60% 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.

In contrast to the company, the rest of the market is expected to grow by 38% over the next year, which really puts the company's recent medium-term earnings decline into perspective.

In light of this, it's alarming that Shenzhen iN-Cube Automation'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 Key Takeaway

We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

We've established that Shenzhen iN-Cube Automation currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. 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. If recent medium-term earnings trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

Plus, you should also learn about these 4 warning signs we've spotted with Shenzhen iN-Cube Automation (including 1 which is concerning).

If you're unsure about the strength of Shenzhen iN-Cube Automation's 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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