When close to half the companies in the Auto Components industry in China have price-to-sales ratios (or "P/S") below 2.2x, you may consider Zhejiang Dehong Automotive Electronic & Electrical Co., Ltd. (SHSE:603701) as a stock to avoid entirely with its 5.3x 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.

How Zhejiang Dehong Automotive Electronic & Electrical Has Been Performing

Revenue has risen firmly for Zhejiang Dehong Automotive Electronic & Electrical recently, which is pleasing to see. Perhaps the market is expecting this decent revenue performance to beat out the industry over the near term, which has kept the P/S propped up. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Is There Enough Revenue Growth Forecasted For Zhejiang Dehong Automotive Electronic & Electrical?

There's an inherent assumption that a company should far outperform the industry for P/S ratios like Zhejiang Dehong Automotive Electronic & Electrical's to be considered reasonable.

If we review the last year of revenue growth, the company posted a terrific increase of 22%. Although, its longer-term performance hasn't been as strong with three-year revenue growth being relatively non-existent overall. Accordingly, shareholders probably wouldn't have been overly satisfied with the unstable medium-term growth rates.

Comparing the recent medium-term revenue trends against the industry's one-year growth forecast of 24% shows it's noticeably less attractive.

In light of this, it's alarming that Zhejiang Dehong Automotive Electronic & Electrical's P/S sits above the majority of other companies. It seems most investors are ignoring the fairly limited recent growth rates and are hoping for a turnaround in the company's business prospects. There's a good chance existing shareholders are setting themselves up for future disappointment if the P/S falls to levels more in line with recent growth rates.

What Does Zhejiang Dehong Automotive Electronic & Electrical's P/S Mean For Investors?

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

The fact that Zhejiang Dehong Automotive Electronic & Electrical currently trades on a higher P/S relative to the industry is an oddity, since its recent three-year growth is lower than the wider industry forecast. When we observe slower-than-industry revenue growth alongside a high P/S ratio, we assume there to be a significant risk of the share price decreasing, which would result in a lower P/S ratio. Unless there is a significant improvement in the company's medium-term performance, it will be difficult to prevent the P/S ratio from declining to a more reasonable level.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 2 warning signs with Zhejiang Dehong Automotive Electronic & Electrical (at least 1 which is concerning), and understanding these should be part of your investment process.

If companies with solid past earnings growth is up your alley, you may wish to see this free collection of other companies with strong earnings growth and low P/E ratios.

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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.