Xiamen Zhongchuang Environmental Technology Co., Ltd (SZSE:300056) shares have had a really impressive month, gaining 27% after a shaky period beforehand. Looking back a bit further, it's encouraging to see the stock is up 29% in the last year.

After such a large jump in price, given around half the companies in China's Machinery industry have price-to-sales ratios (or "P/S") below 2.3x, you may consider Xiamen Zhongchuang Environmental Technology as a stock to avoid entirely with its 6.5x P/S ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/S.

What Does Xiamen Zhongchuang Environmental Technology's P/S Mean For Shareholders?

As an illustration, revenue has deteriorated at Xiamen Zhongchuang Environmental Technology over the last year, which is not ideal at all. Perhaps the market believes the company can do enough to outperform the rest of the industry in the near future, which is keeping the P/S ratio high. If not, then existing shareholders may be quite nervous about the viability of the share price.

Do Revenue Forecasts Match The High P/S Ratio?

The only time you'd be truly comfortable seeing a P/S as steep as Xiamen Zhongchuang Environmental Technology's is when the company's growth is on track to outshine the industry decidedly.

Taking a look back first, the company's revenue growth last year wasn't something to get excited about as it posted a disappointing decline of 18%. As a result, revenue from three years ago have also fallen 70% overall. So unfortunately, we have to acknowledge that the company has not done a great job of growing revenue over that time.

In contrast to the company, the rest of the industry is expected to grow by 23% over the next year, which really puts the company's recent medium-term revenue decline into perspective.

With this in mind, we find it worrying that Xiamen Zhongchuang Environmental Technology's P/S exceeds that of its industry peers. 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 revenue trends is likely to weigh heavily on the share price eventually.

What We Can Learn From Xiamen Zhongchuang Environmental Technology's P/S?

The strong share price surge has lead to Xiamen Zhongchuang Environmental Technology's P/S soaring as well. It's argued the price-to-sales ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

Our examination of Xiamen Zhongchuang Environmental Technology revealed its shrinking revenue over the medium-term isn't resulting in a P/S as low as we expected, given the industry is set to grow. Right now we aren't comfortable with the high P/S as this revenue performance is highly unlikely to support such positive sentiment for long. Unless the recent medium-term conditions improve markedly, investors will have a hard time accepting the share price as fair value.

You need to take note of risks, for example - Xiamen Zhongchuang Environmental Technology has 3 warning signs (and 2 which shouldn't be ignored) we think 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 if growing profitability aligns with your idea of a great company, take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).

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.