Despite an already strong run, Three Squirrels Inc. (SZSE:300783) shares have been powering on, with a gain of 41% in the last thirty days. Looking back a bit further, it's encouraging to see the stock is up 95% in the last year.

Although its price has surged higher, you could still be forgiven for feeling indifferent about Three Squirrels' P/E ratio of 36x, since the median price-to-earnings (or "P/E") ratio in China is also close to 36x. While this might not raise any eyebrows, if the P/E ratio is not justified investors could be missing out on a potential opportunity or ignoring looming disappointment.

Three Squirrels certainly has been doing a good job lately as its earnings growth has been positive while most other companies have been seeing their earnings go backwards. One possibility is that the P/E is moderate because investors think the company's earnings will be less resilient moving forward. If you like the company, you'd be hoping this isn't the case so that you could potentially pick up some stock while it's not quite in favour.

Does Growth Match The P/E?

There's an inherent assumption that a company should be matching the market for P/E ratios like Three Squirrels' to be considered reasonable.

Retrospectively, the last year delivered an exceptional 94% gain to the company's bottom line. However, this wasn't enough as the latest three year period has seen a very unpleasant 18% drop in EPS in aggregate. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Looking ahead now, EPS is anticipated to climb by 24% during the coming year according to the nine analysts following the company. Meanwhile, the rest of the market is forecast to expand by 41%, which is noticeably more attractive.

With this information, we find it interesting that Three Squirrels is trading at a fairly similar P/E to the market. It seems most investors are ignoring the fairly limited growth expectations and are willing to pay up for exposure to the stock. These shareholders may be setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.

The Key Takeaway

Three Squirrels' stock has a lot of momentum behind it lately, which has brought its P/E level with the market. Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.

We've established that Three Squirrels currently trades on a higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the moderate P/E lower. Unless these conditions improve, it's challenging to accept these prices as being reasonable.

Before you settle on your opinion, we've discovered 3 warning signs for Three Squirrels that you should be aware of.

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.