When close to half the companies in China have price-to-earnings ratios (or "P/E's") below 31x, you may consider Shenzhen SDG Service Co.,Ltd. (SZSE:300917) as a stock to potentially avoid with its 38.2x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

Earnings have risen at a steady rate over the last year for Shenzhen SDG ServiceLtd, which is generally not a bad outcome. One possibility is that the P/E is high because investors think this good earnings growth will be enough 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.

How Is Shenzhen SDG ServiceLtd's Growth Trending?

The only time you'd be truly comfortable seeing a P/E as high as Shenzhen SDG ServiceLtd's is when the company's growth is on track to outshine the market.

Retrospectively, the last year delivered a decent 4.5% gain to the company's bottom line. Ultimately though, it couldn't turn around the poor performance of the prior period, with EPS shrinking 11% in total over the last three years. 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 38% 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 Shenzhen SDG ServiceLtd's P/E sits above the majority of other companies. It seems most investors are ignoring the recent poor growth rate and are hoping for a turnaround in the company's business prospects. 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

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 Shenzhen SDG ServiceLtd 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. Right now we are increasingly uncomfortable with the high P/E as this earnings performance is highly unlikely to support such positive sentiment for long. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.

Plus, you should also learn about these 2 warning signs we've spotted with Shenzhen SDG ServiceLtd.

Of course, you might also be able to find a better stock than Shenzhen SDG ServiceLtd. 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.