Shanghai Hugong Electric Group Co.,Ltd.'s (SHSE:603131) price-to-sales (or "P/S") ratio of 3.6x may not look like an appealing investment opportunity when you consider close to half the companies in the Machinery industry in China have P/S ratios below 2.3x. Although, it's not wise to just take the P/S at face value as there may be an explanation why it's as high as it is.

How Shanghai Hugong Electric GroupLtd Has Been Performing

Revenue has risen firmly for Shanghai Hugong Electric GroupLtd recently, which is pleasing to see. Perhaps the market is expecting this decent revenue performance to beat out the industry over the near term, which has kept the P/S propped up. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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

There's an inherent assumption that a company should outperform the industry for P/S ratios like Shanghai Hugong Electric GroupLtd's to be considered reasonable.

Retrospectively, the last year delivered a decent 13% gain to the company's revenues. Ultimately though, it couldn't turn around the poor performance of the prior period, with revenue shrinking 11% in total over the last three years. Therefore, it's fair to say the revenue growth recently has been undesirable for the company.

Weighing that medium-term revenue trajectory against the broader industry's one-year forecast for expansion of 22% shows it's an unpleasant look.

In light of this, it's alarming that Shanghai Hugong Electric GroupLtd's P/S 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 revenue trends is likely to weigh heavily on the share price eventually.

What Does Shanghai Hugong Electric GroupLtd's P/S Mean For Investors?

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

We've established that Shanghai Hugong Electric GroupLtd currently trades on a much higher than expected P/S since its recent revenues have been in decline over the medium-term. When we see revenue heading backwards and underperforming the industry forecasts, we feel the possibility of the share price declining is very real, bringing the P/S back into the realm of reasonability. Unless the recent medium-term conditions improve markedly, investors will have a hard time accepting the share price as fair value.

There are also other vital risk factors to consider and we've discovered 2 warning signs for Shanghai Hugong Electric GroupLtd (1 is significant!) that you should be aware of before investing here.

Of course, profitable companies with a history of great earnings growth are generally safer bets. 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.

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