The Merit Interactive Co.,Ltd. (SZSE:300766) share price has done very well over the last month, posting an excellent gain of 41%. Not all shareholders will be feeling jubilant, since the share price is still down a very disappointing 11% in the last twelve months.

Since its price has surged higher, given around half the companies in China's IT industry have price-to-sales ratios (or "P/S") below 3.8x, you may consider Merit InteractiveLtd as a stock to avoid entirely with its 12.7x 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.

What Does Merit InteractiveLtd's P/S Mean For Shareholders?

As an illustration, revenue has deteriorated at Merit InteractiveLtd over the last year, which is not ideal at all. Perhaps the market believes the company can do enough to outperform the rest of the industry in the near future, which is keeping the P/S ratio high. 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 Merit InteractiveLtd's to be considered reasonable.

Retrospectively, the last year delivered a frustrating 4.4% decrease to the company's top line. As a result, revenue from three years ago have also fallen 19% overall. 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 20% growth in the next 12 months, the company's downward momentum based on recent medium-term revenue results is a sobering picture.

With this in mind, we find it worrying that Merit InteractiveLtd's P/S exceeds that of its industry peers. 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.

What We Can Learn From Merit InteractiveLtd's P/S?

Merit InteractiveLtd's P/S has grown nicely over the last month thanks to a handy boost in the share price. We'd say the price-to-sales ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

Our examination of Merit InteractiveLtd 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. 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 should always think about risks. Case in point, we've spotted 2 warning signs for Merit InteractiveLtd you should be aware of, and 1 of them makes us a bit uncomfortable.

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).

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