Hangzhou Cogeneration Group Co., Ltd.'s (SHSE:605011) price-to-earnings (or "P/E") ratio of 34.1x 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 15x are quite common. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

The recent earnings growth at Hangzhou Cogeneration Group would have to be considered satisfactory if not spectacular. It might be that many expect the reasonable earnings performance to beat most other companies over the coming period, which has increased investors' willingness to pay up for the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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

Hangzhou Cogeneration Group's P/E ratio would be typical for a company that's expected to deliver solid growth, and importantly, perform better than the market.

Taking a look back first, we see that the company managed to grow earnings per share by a handy 5.8% last year. However, this wasn't enough as the latest three year period has seen an unpleasant 30% overall drop in EPS. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

In contrast to the company, the rest of the market is expected to grow by 38% over the next year, which really puts the company's recent medium-term earnings decline into perspective.

In light of this, it's alarming that Hangzhou Cogeneration Group'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 Key Takeaway

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.

We've established that Hangzhou Cogeneration Group currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. 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. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

And what about other risks? Every company has them, and we've spotted 2 warning signs for Hangzhou Cogeneration Group (of which 1 is significant!) 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.