Lihuayi Weiyuan Chemical Co., Ltd.'s (SHSE:600955) price-to-earnings (or "P/E") ratio of 78.8x 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 26x and even P/E's below 16x 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.

Lihuayi Weiyuan Chemical hasn't been tracking well recently as its declining earnings compare poorly to other companies, which have seen some growth on average. It might be that many expect the dour earnings performance to recover substantially, which has kept the P/E from collapsing. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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 Lihuayi Weiyuan Chemical's to be considered reasonable.

Retrospectively, the last year delivered a frustrating 74% decrease to the company's bottom line. The last three years don't look nice either as the company has shrunk EPS by 94% in aggregate. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Shifting to the future, estimates from the sole analyst covering the company suggest earnings should grow by 58% per year over the next three years. That's shaping up to be materially higher than the 23% per annum growth forecast for the broader market.

With this information, we can see why Lihuayi Weiyuan Chemical is trading at such a high P/E compared to the market. Apparently shareholders aren't keen to offload something that is potentially eyeing a more prosperous future.

The Key Takeaway

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 Lihuayi Weiyuan Chemical 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. Unless these conditions change, they will continue to provide strong support to the share price.

And what about other risks? Every company has them, and we've spotted 2 warning signs for Lihuayi Weiyuan Chemical (of which 1 can't be ignored!) you should know about.

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.