Shanghai Xintonglian Packaging Co., Ltd. (SHSE:603022) shareholders that were waiting for something to happen have been dealt a blow with a 28% share price drop in the last month. The drop over the last 30 days has capped off a tough year for shareholders, with the share price down 24% in that time.

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 27x, you may still consider Shanghai Xintonglian Packaging as a stock to potentially avoid with its 39.7x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

With earnings growth that's exceedingly strong of late, Shanghai Xintonglian Packaging has been doing very well. It seems that many are expecting the strong earnings performance to beat most other companies over the coming period, which has increased investors' willingness to pay up for the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Is There Enough Growth For Shanghai Xintonglian Packaging?

The only time you'd be truly comfortable seeing a P/E as high as Shanghai Xintonglian Packaging's is when the company's growth is on track to outshine the market.

Taking a look back first, we see that the company grew earnings per share by an impressive 37% last year. The latest three year period has also seen a 17% overall rise in EPS, aided extensively by its short-term performance. Therefore, it's fair to say the earnings growth recently has been respectable for the company.

This is in contrast to the rest of the market, which is expected to grow by 41% over the next year, materially higher than the company's recent medium-term annualised growth rates.

In light of this, it's alarming that Shanghai Xintonglian Packaging'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, Shanghai Xintonglian Packaging's P/E remains higher than most other companies. We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

We've established that Shanghai Xintonglian Packaging 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.

Don't forget that there may be other risks. For instance, we've identified 1 warning sign for Shanghai Xintonglian Packaging that you should be aware of.

Of course, you might also be able to find a better stock than Shanghai Xintonglian Packaging. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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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.