Cathay Biotech Inc.'s (SHSE:688065) price-to-earnings (or "P/E") ratio of 54.3x might make it look like a strong sell right now compared to the market in China, where around half of the companies have P/E ratios below 28x and even P/E's below 17x are quite common. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

For example, consider that Cathay Biotech's financial performance has been poor lately as its earnings have been in decline. One possibility is that the P/E is high because investors think the company will still do enough to outperform the broader market in the near future. If not, then existing shareholders may be quite nervous about the viability of the share price.

How Is Cathay Biotech's Growth Trending?

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

Retrospectively, the last year delivered a frustrating 5.6% decrease to the company's bottom line. The last three years don't look nice either as the company has shrunk EPS by 17% in aggregate. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

In contrast to the company, the rest of the market is expected to grow by 36% 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 Cathay Biotech 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

It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

Our examination of Cathay Biotech 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. 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.

You always need to take note of risks, for example - Cathay Biotech has 1 warning sign we think you should be aware of.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with a strong growth track record, trading on 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.

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