Hubei Hongyuan Pharmaceutical Technology Co., Ltd.'s (SZSE:301246) price-to-earnings (or "P/E") ratio of 54.1x might make it look like a strong sell right now compared to the market in China, where around half of the companies have P/E ratios below 33x and even P/E's below 19x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

For example, consider that Hubei Hongyuan Pharmaceutical Technology'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.

See our latest analysis for Hubei Hongyuan Pharmaceutical Technology

Is There Enough Growth For Hubei Hongyuan Pharmaceutical Technology?

In order to justify its P/E ratio, Hubei Hongyuan Pharmaceutical Technology would need to produce outstanding growth well in excess of the market.

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 66%. As a result, earnings from three years ago have also fallen 8.6% overall. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

In contrast to the company, the rest of the market is expected to grow by 44% over the next year, which really puts the company's recent medium-term earnings decline into perspective.

With this information, we find it concerning that Hubei Hongyuan Pharmaceutical Technology 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 Final Word

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 Hubei Hongyuan Pharmaceutical Technology 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. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

And what about other risks? Every company has them, and we've spotted 2 warning signs for Hubei Hongyuan Pharmaceutical Technology (of which 1 doesn't sit too well with us!) you should know about.

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.