Newborn Town Inc. (HKG:9911) shares have continued their recent momentum with a 34% gain in the last month alone. 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 Newborn Town's P/E ratio of 7.5x, since the median price-to-earnings (or "P/E") ratio in Hong Kong is also close to 9x. 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.

Newborn Town certainly has been doing a good job lately as it's been growing earnings more than most other companies. It might be that many expect the strong earnings performance to wane, which has kept the P/E from rising. 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?

Newborn Town's P/E ratio would be typical for a company that's only expected to deliver moderate growth, and importantly, perform in line with the market.

Retrospectively, the last year delivered an exceptional 293% gain to the company's bottom line. The latest three year period has also seen an excellent 1,006% overall rise in EPS, aided by its short-term performance. So we can start by confirming that the company has done a great job of growing earnings over that time.

Turning to the outlook, the next three years should generate growth of 4.1% per annum as estimated by the four analysts watching the company. That's shaping up to be materially lower than the 16% per year growth forecast for the broader market.

In light of this, it's curious that Newborn Town's P/E sits in line with the majority of other companies. Apparently many investors in the company are less bearish than analysts indicate and aren't willing to let go of their stock right now. 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 Final Word

Its shares have lifted substantially and now Newborn Town's P/E is also back up to the market median. 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.

Our examination of Newborn Town's analyst forecasts revealed that its inferior earnings outlook isn't impacting its P/E as much as we would have predicted. Right now we are uncomfortable with the P/E as the predicted future earnings aren't likely to support a more positive sentiment for long. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 2 warning signs with Newborn Town (at least 1 which is a bit concerning), and understanding them should be part of your investment process.

If P/E ratios interest you, 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.