The NanJing AoLian AE&EA Co.,Ltd (SZSE:300585) share price has softened a substantial 29% over the previous 30 days, handing back much of the gains the stock has made lately. The drop over the last 30 days has capped off a tough year for shareholders, with the share price down 25% in that time.

Even after such a large drop in price, when almost half of the companies in China's Auto Components industry have price-to-sales ratios (or "P/S") below 2.3x, you may still consider NanJing AoLian AE&EALtd as a stock not worth researching with its 4.4x P/S ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/S.

What Does NanJing AoLian AE&EALtd's P/S Mean For Shareholders?

NanJing AoLian AE&EALtd has been doing a good job lately as it's been growing revenue at a solid pace. One possibility is that the P/S ratio is high because investors think this respectable revenue growth will be enough to outperform the broader industry in the near future. If not, then existing shareholders may be a little nervous about the viability of the share price.

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

There's an inherent assumption that a company should far outperform the industry for P/S ratios like NanJing AoLian AE&EALtd's to be considered reasonable.

If we review the last year of revenue growth, the company posted a terrific increase of 17%. As a result, it also grew revenue by 7.5% in total over the last three years. Accordingly, shareholders would have probably been satisfied with the medium-term rates of revenue growth.

This is in contrast to the rest of the industry, which is expected to grow by 25% over the next year, materially higher than the company's recent medium-term annualised growth rates.

With this information, we find it concerning that NanJing AoLian AE&EALtd is trading at a P/S higher than the industry. 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

Even after such a strong price drop, NanJing AoLian AE&EALtd's P/S still exceeds the industry median significantly. Generally, our preference is to limit the use of the price-to-sales ratio to establishing what the market thinks about the overall health of a company.

Our examination of NanJing AoLian AE&EALtd revealed its poor three-year revenue trends aren't detracting from the P/S as much as we though, given they look worse than current industry expectations. When we observe slower-than-industry revenue growth alongside a high P/S ratio, we assume there to be a significant risk of the share price decreasing, which would result in a lower P/S ratio. Unless there is a significant improvement in the company's medium-term performance, it will be difficult to prevent the P/S ratio from declining to a more reasonable level.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 4 warning signs with NanJing AoLian AE&EALtd (at least 2 which are potentially serious), and understanding these should be part of your investment process.

If you're unsure about the strength of NanJing AoLian AE&EALtd'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.