Xiamen Leading Optics Co., Ltd. (SHSE:605118) shareholders are no doubt pleased to see that the share price has bounced 25% in the last month, although it is still struggling to make up recently lost ground. Taking a wider view, although not as strong as the last month, the full year gain of 19% is also fairly reasonable.

Following the firm bounce in price, given close to half the companies in China have price-to-earnings ratios (or "P/E's") below 29x, you may consider Xiamen Leading Optics as a stock to avoid entirely with its 51.1x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

For example, consider that Xiamen Leading Optics' financial performance has been poor lately as its earnings have been in decline. One possibility is that the P/E is high because investors think the company will still do enough to outperform the broader market in the near future. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Is There Enough Growth For Xiamen Leading Optics?

Xiamen Leading Optics' 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.

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 22%. This means it has also seen a slide in earnings over the longer-term as EPS is down 26% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

In contrast to the company, the rest of the market is expected to grow by 41% 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 Xiamen Leading Optics' P/E sits above the majority of other companies. Apparently many investors in the company are way more bullish than recent times would indicate and aren't willing to let go of their stock at any price. There's a very good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the recent negative growth rates.

The Bottom Line On Xiamen Leading Optics' P/E

The strong share price surge has got Xiamen Leading Optics' P/E rushing to great heights as well. Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

Our examination of Xiamen Leading Optics 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. When we see earnings heading backwards and underperforming the market forecasts, we suspect the share price is at risk of declining, sending the high P/E lower. 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.

And what about other risks? Every company has them, and we've spotted 3 warning signs for Xiamen Leading Optics (of which 2 shouldn't be ignored!) you should know about.

Of course, you might also be able to find a better stock than Xiamen Leading Optics. 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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