To the annoyance of some shareholders, Sichuan Joyou Digital Technologies Co.,Ltd. (SZSE:301172) shares are down a considerable 28% in the last month, which continues a horrid run for the company. To make matters worse, the recent drop has wiped out a year's worth of gains with the share price now back where it started a year ago.

Even after such a large drop in price, Sichuan Joyou Digital TechnologiesLtd may still be sending very bearish signals at the moment with a price-to-earnings (or "P/E") ratio of 49.8x, 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 quite high for a reason and it requires further investigation to determine if it's justified.

Sichuan Joyou Digital TechnologiesLtd has been doing a good job lately as it's been growing earnings at a solid pace. One possibility is that the P/E is high because investors think this respectable earnings growth will be enough to outperform the broader market in the near future. If not, then existing shareholders may be a little nervous about the viability of the share price.

How Is Sichuan Joyou Digital TechnologiesLtd's Growth Trending?

There's an inherent assumption that a company should far outperform the market for P/E ratios like Sichuan Joyou Digital TechnologiesLtd's to be considered reasonable.

If we review the last year of earnings growth, the company posted a worthy increase of 8.6%. However, this wasn't enough as the latest three year period has seen an unpleasant 18% overall drop in EPS. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

In contrast to the company, the rest of the market is expected to grow by 41% over the next year, which really puts the company's recent medium-term earnings decline into perspective.

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

The Final Word

Sichuan Joyou Digital TechnologiesLtd's shares may have retreated, but its P/E is still flying high. 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.

Our examination of Sichuan Joyou Digital TechnologiesLtd revealed its shrinking earnings over the medium-term aren't impacting its high P/E anywhere near as much as we would have predicted, given the market is set to grow. When we see earnings heading backwards and underperforming the market forecasts, we suspect the share price is at risk of declining, sending the high P/E lower. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

Before you settle on your opinion, we've discovered 3 warning signs for Sichuan Joyou Digital TechnologiesLtd (2 make us uncomfortable!) that you should be aware of.

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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