Zotye Automobile Co., Ltd (SZSE:000980) shares have continued their recent momentum with a 43% gain in the last month alone. Unfortunately, the gains of the last month did little to right the losses of the last year with the stock still down 29% over that time.

After such a large jump in price, given around half the companies in China's Auto industry have price-to-sales ratios (or "P/S") below 2x, you may consider Zotye Automobile as a stock to avoid entirely with its 22.4x P/S ratio. However, the P/S might be quite high for a reason and it requires further investigation to determine if it's justified.

What Does Zotye Automobile's P/S Mean For Shareholders?

For instance, Zotye Automobile's receding revenue in recent times would have to be some food for thought. 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.

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

In order to justify its P/S ratio, Zotye Automobile would need to produce outstanding growth that's well in excess of the industry.

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 29%. The last three years don't look nice either as the company has shrunk revenue by 39% in aggregate. Therefore, it's fair to say the revenue growth recently has been undesirable for the company.

In contrast to the company, the rest of the industry is expected to grow by 36% 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 Zotye Automobile 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. 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

The strong share price surge has lead to Zotye Automobile's P/S soaring as well. 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 Zotye Automobile 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. With a revenue decline on investors' minds, the likelihood of a souring sentiment is quite high which could send the P/S back in line with what we'd expect. 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.

You should always think about risks. Case in point, we've spotted 1 warning sign for Zotye Automobile you should be aware of.

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

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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.