When you see that almost half of the companies in the Machinery industry in China have price-to-sales ratios (or "P/S") below 2.6x, RongFa Nuclear Equipment Co., Ltd. (SZSE:002366) looks to be giving off strong sell signals with its 11.2x P/S ratio. However, the P/S might be quite high for a reason and it requires further investigation to determine if it's justified.

How Has RongFa Nuclear Equipment Performed Recently?

With revenue growth that's exceedingly strong of late, RongFa Nuclear Equipment has been doing very well. Perhaps the market is expecting future revenue performance to outperform the wider market, which has seemingly got people interested in the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Do Revenue Forecasts Match The High P/S Ratio?

The only time you'd be truly comfortable seeing a P/S as steep as RongFa Nuclear Equipment's is when the company's growth is on track to outshine the industry decidedly.

Retrospectively, the last year delivered an exceptional 64% gain to the company's top line. The strong recent performance means it was also able to grow revenue by 76% in total over the last three years. So we can start by confirming that the company has done a great job of growing revenue over that time.

Comparing the recent medium-term revenue trends against the industry's one-year growth forecast of 25% shows it's noticeably less attractive.

In light of this, it's alarming that RongFa Nuclear Equipment's P/S 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. Only the boldest would assume these prices are sustainable as a continuation of recent revenue trends is likely to weigh heavily on the share price eventually.

The Final Word

Typically, we'd caution against reading too much into price-to-sales ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

The fact that RongFa Nuclear Equipment currently trades on a higher P/S relative to the industry is an oddity, since its recent three-year growth is lower than the wider industry forecast. When we see slower than industry revenue growth but an elevated P/S, there's considerable risk of the share price declining, sending the P/S lower. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these the share price as being reasonable.

It is also worth noting that we have found 2 warning signs for RongFa Nuclear Equipment (1 is potentially serious!) that you need to take into consideration.

Of course, profitable companies with a history of great earnings growth are generally safer bets. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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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.