Shenzhen Original Advanced Compounds Co., Ltd. (SHSE:603991) shares have had a horrible month, losing 28% after a relatively good period beforehand. Instead of being rewarded, shareholders who have already held through the last twelve months are now sitting on a 15% share price drop.

Although its price has dipped substantially, you could still be forgiven for thinking Shenzhen Original Advanced Compounds is a stock to steer clear of with a price-to-sales ratios (or "P/S") of 11.9x, considering almost half the companies in China's Chemicals industry have P/S ratios below 1.9x. 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.

What Does Shenzhen Original Advanced Compounds' P/S Mean For Shareholders?

Recent times have been quite advantageous for Shenzhen Original Advanced Compounds as its revenue has been rising very briskly. The P/S ratio is probably high because investors think this strong revenue growth will be enough to outperform the broader industry in the near future. 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 Shenzhen Original Advanced Compounds?

There's an inherent assumption that a company should far outperform the industry for P/S ratios like Shenzhen Original Advanced Compounds' to be considered reasonable.

Taking a look back first, we see that the company grew revenue by an impressive 113% last year. However, this wasn't enough as the latest three year period has seen the company endure a nasty 44% drop in revenue in aggregate. Therefore, it's fair to say the revenue growth recently has been undesirable for the company.

Comparing that to the industry, which is predicted to deliver 26% growth in the next 12 months, the company's downward momentum based on recent medium-term revenue results is a sobering picture.

With this information, we find it concerning that Shenzhen Original Advanced Compounds is trading at a P/S higher than the industry. 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

Even after such a strong price drop, Shenzhen Original Advanced Compounds' P/S still exceeds the industry median significantly. Typically, we'd caution against reading too much into price-to-sales ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

We've established that Shenzhen Original Advanced Compounds 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. If recent medium-term revenue trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

Before you take the next step, you should know about the 3 warning signs for Shenzhen Original Advanced Compounds that we have uncovered.

If strong companies turning a profit tickle your fancy, then you'll want to check out this free list of interesting companies that trade on a low P/E (but have proven they can grow earnings).

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.