Hangzhou Zhongya Machinery Co., Ltd. (SZSE:300512) shares have had a horrible month, losing 26% 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 18% share price drop.

Even after such a large drop in price, given around half the companies in China have price-to-earnings ratios (or "P/E's") below 29x, you may still consider Hangzhou Zhongya Machinery as a stock to potentially avoid with its 38.4x P/E ratio. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's as high as it is.

As an illustration, earnings have deteriorated at Hangzhou Zhongya Machinery over the last year, which is not ideal at all. One possibility is that the P/E is high because investors think the company will still do enough to outperform the broader market in the near future. If not, then existing shareholders may be quite nervous about the viability of the share price.

Check out our latest analysis for Hangzhou Zhongya Machinery

How Is Hangzhou Zhongya Machinery's Growth Trending?

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

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 29%. That put a dampener on the good run it was having over the longer-term as its three-year EPS growth is still a noteworthy 29% in total. Although it's been a bumpy ride, it's still fair to say the earnings growth recently has been mostly respectable for the company.

Comparing that to the market, which is predicted to deliver 42% growth in the next 12 months, the company's momentum is weaker based on recent medium-term annualised earnings results.

In light of this, it's alarming that Hangzhou Zhongya Machinery's P/E sits above the majority of other companies. It seems most investors are ignoring the fairly limited recent growth rates and are hoping for a turnaround in the company's business prospects. There's a good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with recent growth rates.

The Final Word

Despite the recent share price weakness, Hangzhou Zhongya Machinery's P/E remains higher than most other companies. It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

We've established that Hangzhou Zhongya Machinery currently trades on a much higher than expected P/E since its recent three-year growth is lower than the wider market forecast. Right now we are increasingly uncomfortable with the high P/E as this earnings performance isn't likely to support such positive sentiment for long. If recent medium-term earnings trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

It is also worth noting that we have found 2 warning signs for Hangzhou Zhongya Machinery (1 is a bit unpleasant!) that you need to take into consideration.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with a strong growth track record, trading on 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.