China Mengniu Dairy Company Limited (HKG:2319) shareholders won't be pleased to see that the share price has had a very rough month, dropping 26% and undoing the prior period's positive performance. For any long-term shareholders, the last month ends a year to forget by locking in a 52% share price decline.

In spite of the heavy fall in price, China Mengniu Dairy may still be sending bearish signals at the moment with its price-to-earnings (or "P/E") ratio of 11.5x, since almost half of all companies in Hong Kong have P/E ratios under 9x and even P/E's lower than 5x are not unusual. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's as high as it is.

While the market has experienced earnings growth lately, China Mengniu Dairy's earnings have gone into reverse gear, which is not great. One possibility is that the P/E is high because investors think this poor earnings performance will turn the corner. If not, then existing shareholders may be extremely nervous about the viability of the share price.

What Are Growth Metrics Telling Us About The High P/E?

China Mengniu Dairy's P/E ratio would be typical for a company that's expected to deliver solid growth, and importantly, perform better than 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 9.1%. However, a few very strong years before that means that it was still able to grow EPS by an impressive 36% in total over the last three years. So we can start by confirming that the company has generally done a very good job of growing earnings over that time, even though it had some hiccups along the way.

Looking ahead now, EPS is anticipated to climb by 12% per annum during the coming three years according to the analysts following the company. That's shaping up to be materially lower than the 15% each year growth forecast for the broader market.

In light of this, it's alarming that China Mengniu Dairy's P/E sits above the majority of other companies. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.

The Key Takeaway

There's still some solid strength behind China Mengniu Dairy's P/E, if not its share price lately. 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 China Mengniu Dairy's analyst forecasts revealed that its inferior earnings outlook isn't impacting its high P/E anywhere near as much as we would have predicted. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

There are also other vital risk factors to consider before investing and we've discovered 1 warning sign for China Mengniu Dairy that you should be aware of.

If you're unsure about the strength of China Mengniu Dairy'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.