Shandong Xinhua Pharmaceutical Company Limited (HKG:719) shares have continued their recent momentum with a 25% gain in the last month alone. The last 30 days bring the annual gain to a very sharp 76%.

Following the firm bounce in price, Shandong Xinhua Pharmaceutical's price-to-earnings (or "P/E") ratio of 11.1x might make it look like a sell right now compared to the market in Hong Kong, where around half of the companies have P/E ratios below 9x and even P/E's below 5x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

Shandong Xinhua Pharmaceutical has been doing a decent job lately as it's been growing earnings at a reasonable pace. One possibility is that the P/E is high because investors think this good earnings growth will be enough to outperform the broader market in the near future. If not, then existing shareholders may be a little nervous about the viability of the share price.

See our latest analysis for Shandong Xinhua Pharmaceutical

Does Growth Match The High P/E?

There's an inherent assumption that a company should outperform the market for P/E ratios like Shandong Xinhua Pharmaceutical's to be considered reasonable.

If we review the last year of earnings growth, the company posted a worthy increase of 4.4%. The solid recent performance means it was also able to grow EPS by 27% in total over the last three years. Accordingly, shareholders would have probably been satisfied with the medium-term rates of earnings growth.

Comparing that to the market, which is predicted to deliver 15% growth in the next 12 months, the company's momentum is weaker based on recent medium-term annualised earnings results.

In light of this, it's alarming that Shandong Xinhua Pharmaceutical's P/E 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/E falls to levels more in line with recent growth rates.

The Final Word

Shandong Xinhua Pharmaceutical shares have received a push in the right direction, but its P/E is elevated too. While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.

We've established that Shandong Xinhua Pharmaceutical currently trades on a much higher than expected P/E since its recent three-year growth is lower than the wider market forecast. Right now we are increasingly uncomfortable with the high P/E as this earnings performance isn't likely 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.

Don't forget that there may be other risks. For instance, we've identified 2 warning signs for Shandong Xinhua Pharmaceutical (1 is significant) you should be aware of.

If these risks are making you reconsider your opinion on Shandong Xinhua Pharmaceutical, 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.