The Chengdu Dahongli Machinery Co.,Ltd. (SZSE:300865) share price has done very well over the last month, posting an excellent gain of 56%. But the gains over the last month weren't enough to make shareholders whole, as the share price is still down 6.0% in the last twelve months.

Since its price has surged higher, when almost half of the companies in China's Machinery industry have price-to-sales ratios (or "P/S") below 2.7x, you may consider Chengdu Dahongli MachineryLtd as a stock probably not worth researching with its 3.5x P/S ratio. Although, it's not wise to just take the P/S at face value as there may be an explanation why it's as high as it is.

How Has Chengdu Dahongli MachineryLtd Performed Recently?

The revenue growth achieved at Chengdu Dahongli MachineryLtd over the last year would be more than acceptable for most companies. One possibility is that the P/S ratio is high because investors think this respectable revenue growth will be enough to outperform the broader industry in the near future. However, if this isn't the case, investors might get caught out paying too much for the stock.

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

Chengdu Dahongli MachineryLtd's P/S ratio would be typical for a company that's expected to deliver solid growth, and importantly, perform better than the industry.

Taking a look back first, we see that the company managed to grow revenues by a handy 12% last year. Still, lamentably revenue has fallen 16% in aggregate from three years ago, which is disappointing. So unfortunately, we have to acknowledge that the company has not done a great job of growing revenue over that time.

Comparing that to the industry, which is predicted to deliver 25% growth in the next 12 months, the company's downward momentum based on recent medium-term revenue results is a sobering picture.

In light of this, it's alarming that Chengdu Dahongli MachineryLtd's P/S sits above the majority of other companies. 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 revenue trends is likely to weigh heavily on the share price eventually.

What We Can Learn From Chengdu Dahongli MachineryLtd's P/S?

Chengdu Dahongli MachineryLtd shares have taken a big step in a northerly direction, but its P/S is elevated as a result. We'd say the price-to-sales ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

We've established that Chengdu Dahongli MachineryLtd currently trades on a much higher than expected P/S since its recent revenues have been in decline over the medium-term. With a revenue decline on investors' minds, the likelihood of a souring sentiment is quite high which could send the P/S back in line with what we'd expect. If recent medium-term revenue trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

You always need to take note of risks, for example - Chengdu Dahongli MachineryLtd has 2 warning signs we think you should be aware of.

Of course, profitable companies with a history of great earnings growth are generally safer bets. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.