Chengdu Dahongli Machinery Co.,Ltd. (SZSE:300865) shareholders would be excited to see that the share price has had a great month, posting a 43% gain and recovering from prior weakness. Not all shareholders will be feeling jubilant, since the share price is still down a very disappointing 14% in the last twelve months.

Since its price has surged higher, when almost half of the companies in China's Machinery industry have price-to-sales ratios (or "P/S") below 2.8x, you may consider Chengdu Dahongli MachineryLtd as a stock probably not worth researching with its 3.4x P/S ratio. 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 Has Chengdu Dahongli MachineryLtd Performed Recently?

With revenue growth that's exceedingly strong of late, Chengdu Dahongli MachineryLtd has been doing very well. It seems that many are expecting the strong revenue performance to beat most other companies over the coming period, which has increased investors' willingness to pay up for the stock. However, if this isn't the case, investors might get caught out paying too much for the stock.

Is There Enough Revenue Growth Forecasted For Chengdu Dahongli MachineryLtd?

In order to justify its P/S ratio, Chengdu Dahongli MachineryLtd would need to produce impressive growth in excess of the industry.

Retrospectively, the last year delivered an exceptional 50% gain to the company's top line. Despite this strong recent growth, it's still struggling to catch up as its three-year revenue frustratingly shrank by 26% overall. Accordingly, shareholders would have felt downbeat about the medium-term rates of revenue growth.

Comparing that to the industry, which is predicted to deliver 23% growth in the next 12 months, the company's downward momentum based on recent medium-term revenue results is a sobering picture.

In light of this, it's alarming that Chengdu Dahongli MachineryLtd's P/S 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 revenue trends is likely to weigh heavily on the share price eventually.

The Key Takeaway

Chengdu Dahongli MachineryLtd shares have taken a big step in a northerly direction, but its P/S is elevated as a result. Generally, our preference is to limit the use of the price-to-sales ratio to establishing what the market thinks about the overall health of a company.

Our examination of Chengdu Dahongli MachineryLtd revealed its shrinking revenue over the medium-term isn't resulting in a P/S as low as we expected, given the industry is set to grow. 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. Should recent medium-term revenue trends persist, it would pose a significant risk to existing shareholders' investments and prospective investors will have a hard time accepting the current value of the stock.

You should always think about risks. Case in point, we've spotted 2 warning signs for Chengdu Dahongli MachineryLtd you should be aware of.

If you're unsure about the strength of Chengdu Dahongli MachineryLtd's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

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