Innuovo Technology Co., Ltd. (SZSE:000795) shareholders that were waiting for something to happen have been dealt a blow with a 28% share price drop in the last month. Instead of being rewarded, shareholders who have already held through the last twelve months are now sitting on a 42% share price drop.

Even after such a large drop in price, Innuovo Technology may still be sending bearish signals at the moment with its price-to-earnings (or "P/E") ratio of 38x, since almost half of all companies in China have P/E ratios under 26x and even P/E's lower than 16x are not unusual. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

As an illustration, earnings have deteriorated at Innuovo Technology over the last year, which is not ideal at all. It might be that many expect the company to still outplay most other companies over the coming period, which has kept the P/E from collapsing. If not, then existing shareholders may be quite nervous about the viability of the share price.

How Is Innuovo Technology's Growth Trending?

In order to justify its P/E ratio, Innuovo Technology would need to produce impressive growth in excess of the market.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 35%. This means it has also seen a slide in earnings over the longer-term as EPS is down 12% in total over the last three years. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

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

With this information, we find it concerning that Innuovo Technology is trading at a P/E higher than the market. 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 earnings trends is likely to weigh heavily on the share price eventually.

The Final Word

There's still some solid strength behind Innuovo Technology's P/E, if not its share price lately. 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 Innuovo Technology currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. Right now we are increasingly uncomfortable with the high P/E as this earnings performance is highly unlikely to support such positive sentiment for long. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 2 warning signs with Innuovo Technology, and understanding them should be part of your investment process.

It's important to make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).

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