Guangzhou Huayan Precision Machinery Co.,Ltd.'s (SZSE:301138) price-to-earnings (or "P/E") ratio of 38.8x might make it look like a sell right now compared to the market in China, where around half of the companies have P/E ratios below 26x and even P/E's below 16x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

As an illustration, earnings have deteriorated at Guangzhou Huayan Precision MachineryLtd over the last year, which is not ideal at all. 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. If not, then existing shareholders may be quite nervous about the viability of the share price.

Is There Enough Growth For Guangzhou Huayan Precision MachineryLtd?

In order to justify its P/E ratio, Guangzhou Huayan Precision MachineryLtd would need to produce impressive growth in excess of the market.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 4.9%. This means it has also seen a slide in earnings over the longer-term as EPS is down 38% in total over the last three years. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Comparing that to the market, which is predicted to deliver 37% 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 Guangzhou Huayan Precision MachineryLtd's 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. 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

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.

Our examination of Guangzhou Huayan Precision MachineryLtd 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. 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.

You need to take note of risks, for example - Guangzhou Huayan Precision MachineryLtd has 4 warning signs (and 2 which are concerning) we think you should know about.

It's important to make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).

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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.