The Xiamen Zhongchuang Environmental Technology Co., Ltd (SZSE:300056) share price has softened a substantial 30% over the previous 30 days, handing back much of the gains the stock has made lately. Still, a bad month hasn't completely ruined the past year with the stock gaining 71%, which is great even in a bull market.

Although its price has dipped substantially, given around half the companies in China's Machinery industry have price-to-sales ratios (or "P/S") below 3.1x, you may still consider Xiamen Zhongchuang Environmental Technology as a stock to avoid entirely with its 11.5x 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 so lofty.

How Xiamen Zhongchuang Environmental Technology Has Been Performing

For example, consider that Xiamen Zhongchuang Environmental Technology's financial performance has been poor lately as its revenue has been in decline. It might be that many expect the company to still outplay most other companies over the coming period, which has kept the P/S from collapsing. However, if this isn't the case, investors might get caught out paying too much for the stock.

Do Revenue Forecasts Match The High P/S Ratio?

There's an inherent assumption that a company should far outperform the industry for P/S ratios like Xiamen Zhongchuang Environmental Technology's to be considered reasonable.

Taking a look back first, the company's revenue growth last year wasn't something to get excited about as it posted a disappointing decline of 20%. As a result, revenue from three years ago have also fallen 65% overall. So unfortunately, we have to acknowledge that the company has not done a great job of growing revenue over that time.

In contrast to the company, the rest of the industry is expected to grow by 24% over the next year, which really puts the company's recent medium-term revenue decline into perspective.

With this information, we find it concerning that Xiamen Zhongchuang Environmental Technology is trading at a P/S higher than the industry. It seems most investors are ignoring the recent poor growth rate and are hoping for a turnaround in the company's business prospects. There's a very good chance existing shareholders are setting themselves up for future disappointment if the P/S falls to levels more in line with the recent negative growth rates.

The Bottom Line On Xiamen Zhongchuang Environmental Technology's P/S

Even after such a strong price drop, Xiamen Zhongchuang Environmental Technology's P/S still exceeds the industry median significantly. 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.

We've established that Xiamen Zhongchuang Environmental Technology currently trades on a much higher than expected P/S since its recent revenues have been in decline over the medium-term. Right now we aren't comfortable with the high P/S as this revenue performance is highly unlikely to support such positive sentiment for long. Unless the the circumstances surrounding the recent medium-term improve, it wouldn't be wrong to expect a a difficult period ahead for the company's shareholders.

You always need to take note of risks, for example - Xiamen Zhongchuang Environmental Technology has 2 warning signs we think you should be aware of.

If these risks are making you reconsider your opinion on Xiamen Zhongchuang Environmental Technology, 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.