Qinghai Huading Industrial Co., Ltd. (SHSE:600243) shares have continued their recent momentum with a 26% gain in the last month alone. Looking further back, the 23% rise over the last twelve months isn't too bad notwithstanding the strength over the last 30 days.

Since its price has surged higher, given around half the companies in China's Machinery industry have price-to-sales ratios (or "P/S") below 3.3x, you may consider Qinghai Huading Industrial as a stock to avoid entirely with its 9x P/S ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/S.

What Does Qinghai Huading Industrial's P/S Mean For Shareholders?

As an illustration, revenue has deteriorated at Qinghai Huading Industrial over the last year, which is not ideal at all. One possibility is that the P/S is high because investors think the company will still do 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.

Do Revenue Forecasts Match The High P/S Ratio?

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

Retrospectively, the last year delivered a frustrating 33% decrease to the company's top line. The last three years don't look nice either as the company has shrunk revenue by 54% in aggregate. Accordingly, shareholders would have felt downbeat about the medium-term rates of revenue growth.

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.

In light of this, it's alarming that Qinghai Huading Industrial's P/S sits above the majority of other companies. 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

Shares in Qinghai Huading Industrial have seen a strong upwards swing lately, which has really helped boost its P/S figure. 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 Qinghai Huading Industrial currently trades on a much higher than expected P/S since its recent revenues have been in decline over the medium-term. 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 recent medium-term conditions improve markedly, investors will have a hard time accepting the share price as fair value.

Many other vital risk factors can be found on the company's balance sheet. Our free balance sheet analysis for Qinghai Huading Industrial with six simple checks will allow you to discover any risks that could be an issue.

If companies with solid past earnings growth is up your alley, you may wish to see this free collection of other companies with strong earnings growth and low P/E ratios.

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.