Edan Instruments, Inc.'s (SZSE:300206) price-to-earnings (or "P/E") ratio of 43.2x 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. 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.

For instance, Edan Instruments' receding earnings in recent times would have to be some food for thought. It might be that many expect the company to still outplay most other companies over the coming period, which has kept the P/E from collapsing. If not, then existing shareholders may be quite nervous about the viability of the share price.

Is There Enough Growth For Edan Instruments?

The only time you'd be truly comfortable seeing a P/E as steep as Edan Instruments' is when the company's growth is on track to outshine the market decidedly.

Retrospectively, the last year delivered a frustrating 63% decrease to the company's bottom line. This means it has also seen a slide in earnings over the longer-term as EPS is down 83% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

In contrast to the company, the rest of the market is expected to grow by 37% 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 Edan Instruments is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than recent times would indicate and aren't willing to let go of their stock at any price. 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 Key Takeaway

Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

Our examination of Edan Instruments 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 need to take note of risks, for example - Edan Instruments has 4 warning signs (and 1 which is a bit concerning) we think you should know about.

If these risks are making you reconsider your opinion on Edan Instruments, explore our interactive list of high quality stocks to get an idea of what else is out there.

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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.