The Zhejiang Changhua Auto Parts Co., Ltd. (SHSE:605018) share price has fared very poorly over the last month, falling by a substantial 26%. Instead of being rewarded, shareholders who have already held through the last twelve months are now sitting on a 28% share price drop.

Although its price has dipped substantially, given around half the companies in China have price-to-earnings ratios (or "P/E's") below 27x, you may still consider Zhejiang Changhua Auto Parts as a stock to potentially avoid with its 38x P/E ratio. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

For instance, Zhejiang Changhua Auto Parts' receding earnings in recent times would have to be some food for thought. 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. If not, then existing shareholders may be quite nervous about the viability of the share price.

How Is Zhejiang Changhua Auto Parts' Growth Trending?

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

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 16%. The last three years don't look nice either as the company has shrunk EPS by 56% in aggregate. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Comparing that to the market, which is predicted to deliver 41% growth in the next 12 months, the company's downward momentum based on recent medium-term earnings results is a sobering picture.

In light of this, it's alarming that Zhejiang Changhua Auto Parts' 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

Zhejiang Changhua Auto Parts' P/E hasn't come down all the way after its stock plunged. While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.

We've established that Zhejiang Changhua Auto Parts 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.

Before you take the next step, you should know about the 2 warning signs for Zhejiang Changhua Auto Parts (1 is a bit unpleasant!) that we have uncovered.

If these risks are making you reconsider your opinion on Zhejiang Changhua Auto Parts, explore our interactive list of high quality stocks to get an idea of what else is out there.

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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.