Despite an already strong run, DHC Software Co.,Ltd. (SZSE:002065) shares have been powering on, with a gain of 42% in the last thirty days. Taking a wider view, although not as strong as the last month, the full year gain of 23% is also fairly reasonable.

Following the firm bounce in price, given close to half the companies in China have price-to-earnings ratios (or "P/E's") below 36x, you may consider DHC SoftwareLtd as a stock to avoid entirely with its 67.7x P/E ratio. 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 example, consider that DHC SoftwareLtd's financial performance has been poor lately as its earnings have been in decline. 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. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Does Growth Match The High P/E?

DHC SoftwareLtd's P/E ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the market.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 14%. The last three years don't look nice either as the company has shrunk EPS by 38% in aggregate. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Comparing that to the market, which is predicted to deliver 40% growth in the next 12 months, the company's downward momentum based on recent medium-term earnings results is a sobering picture.

With this information, we find it concerning that DHC SoftwareLtd is trading at a P/E higher than the market. It seems most investors are ignoring the recent poor growth rate and are hoping for a turnaround in the company's business prospects. 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 Bottom Line On DHC SoftwareLtd's P/E

Shares in DHC SoftwareLtd have built up some good momentum lately, which has really inflated its P/E. We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

We've established that DHC SoftwareLtd currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. When we see earnings heading backwards and underperforming the market forecasts, we suspect the share price is at risk of declining, sending the high P/E lower. If recent medium-term earnings trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

Plus, you should also learn about these 3 warning signs we've spotted with DHC SoftwareLtd (including 1 which is a bit unpleasant).

If you're unsure about the strength of DHC SoftwareLtd's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

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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.