When you see that almost half of the companies in the IT industry in China have price-to-sales ratios (or "P/S") below 3.4x, Leon Technology Co., Ltd. (SZSE:300603) looks to be giving off strong sell signals with its 5.6x 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.

How Leon Technology Has Been Performing

As an illustration, revenue has deteriorated at Leon Technology 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.

Is There Enough Revenue Growth Forecasted For Leon Technology?

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

Retrospectively, the last year delivered a frustrating 18% decrease to the company's top line. As a result, revenue from three years ago have also fallen 58% overall. So unfortunately, we have to acknowledge that the company has not done a great job of growing revenue over that time.

In contrast to the company, the rest of the industry is expected to grow by 45% 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 Leon Technology is trading at a P/S higher than the industry. 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.

The Key Takeaway

It's argued the price-to-sales ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

Our examination of Leon Technology 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. 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.

Plus, you should also learn about these 3 warning signs we've spotted with Leon Technology (including 1 which is a bit concerning).

It's important to make sure you look for a great company, not just the first idea you come across. So if growing profitability aligns with your idea of a great company, 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.