The Digital China Holdings Limited (HKG:861) share price has done very well over the last month, posting an excellent gain of 27%. Not all shareholders will be feeling jubilant, since the share price is still down a very disappointing 25% in the last twelve months.

After such a large jump in price, given close to half the companies in Hong Kong have price-to-earnings ratios (or "P/E's") below 8x, you may consider Digital China Holdings as a stock to avoid entirely with its 26.4x 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 so lofty.

Recent times haven't been advantageous for Digital China Holdings as its earnings have been falling quicker than most other companies. It might be that many expect the dismal earnings performance to recover substantially, which has kept the P/E from collapsing. If not, then existing shareholders may be very nervous about the viability of the share price.

What Are Growth Metrics Telling Us About The High P/E?

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

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 73%. This means it has also seen a slide in earnings over the longer-term as EPS is down 68% 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.

Looking ahead now, EPS is anticipated to climb by 52% per year during the coming three years according to the two analysts following the company. With the market only predicted to deliver 15% per year, the company is positioned for a stronger earnings result.

With this information, we can see why Digital China Holdings is trading at such a high P/E compared to the market. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Key Takeaway

The strong share price surge has got Digital China Holdings' P/E rushing to great heights as well. 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 Digital China Holdings maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. Right now shareholders are comfortable with the P/E as they are quite confident future earnings aren't under threat. It's hard to see the share price falling strongly in the near future under these circumstances.

You should always think about risks. Case in point, we've spotted 2 warning signs for Digital China Holdings 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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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.