With a price-to-earnings (or "P/E") ratio of 40.1x GemPharmatech Co., Ltd. (SHSE:688046) may be sending bearish signals at the moment, given that almost half of all companies in China have P/E ratios under 31x and even P/E's lower than 18x are not unusual. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

GemPharmatech hasn't been tracking well recently as its declining earnings compare poorly to other companies, which have seen some growth on average. One possibility is that the P/E is high because investors think this poor earnings performance will turn the corner. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Is There Enough Growth For GemPharmatech?

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

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 7.1%. Even so, admirably EPS has lifted 85% in aggregate from three years ago, notwithstanding the last 12 months. Accordingly, while they would have preferred to keep the run going, shareholders would probably welcome the medium-term rates of earnings growth.

Shifting to the future, estimates from the eight analysts covering the company suggest earnings should grow by 26% over the next year. With the market predicted to deliver 41% growth , the company is positioned for a weaker earnings result.

With this information, we find it concerning that GemPharmatech is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.

What We Can Learn From GemPharmatech's P/E?

While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.

We've established that GemPharmatech currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

The company's balance sheet is another key area for risk analysis. Our free balance sheet analysis for GemPharmatech with six simple checks will allow you to discover any risks that could be an issue.

Of course, you might also be able to find a better stock than GemPharmatech. 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.