Those holding Shandong Longji Machinery Co.,Ltd (SZSE:002363) shares would be relieved that the share price has rebounded 34% in the last thirty days, but it needs to keep going to repair the recent damage it has caused to investor portfolios. Longer-term shareholders would be thankful for the recovery in the share price since it's now virtually flat for the year after the recent bounce.

After such a large jump in price, Shandong Longji MachineryLtd may be sending very bearish signals at the moment with a price-to-earnings (or "P/E") ratio of 71.8x, since almost half of all companies in China have P/E ratios under 31x and even P/E's lower than 19x are not unusual. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

It looks like earnings growth has deserted Shandong Longji MachineryLtd recently, which is not something to boast about. One possibility is that the P/E is high because investors think the benign earnings growth will improve 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.

Is There Enough Growth For Shandong Longji MachineryLtd?

The only time you'd be truly comfortable seeing a P/E as steep as Shandong Longji MachineryLtd's is when the company's growth is on track to outshine the market decidedly.

Taking a look back first, we see that there was hardly any earnings per share growth to speak of for the company over the past year. The lack of growth did nothing to help the company's aggregate three-year performance, which is an unsavory 8.7% drop in EPS. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

In contrast to the company, the rest of the market is expected to grow by 40% over the next year, which really puts the company's recent medium-term earnings decline into perspective.

In light of this, it's alarming that Shandong Longji MachineryLtd's P/E sits above the majority of other companies. Apparently many investors in the company are way more bullish than recent times would indicate and aren't willing to let go of their stock at any price. There's a very good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the recent negative growth rates.

The Key Takeaway

Shandong Longji MachineryLtd's P/E is flying high just like its stock has during the last month. Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

Our examination of Shandong Longji MachineryLtd revealed its shrinking earnings over the medium-term aren't impacting its high P/E anywhere near as much as we would have predicted, given the market is set to grow. 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 3 warning signs for Shandong Longji MachineryLtd (of which 1 is a bit unpleasant!) 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.