When close to half the companies in China have price-to-earnings ratios (or "P/E's") below 30x, you may consider Zhejiang Changhua Auto Parts Co., Ltd. (SHSE:605018) as a stock to potentially avoid with its 40x P/E ratio. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's lofty.

We'd have to say that with no tangible growth over the last year, Zhejiang Changhua Auto Parts' earnings have been unimpressive. It might be that many are expecting an improvement to the uninspiring earnings performance over the coming period, which has kept the P/E from collapsing. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Check out our latest analysis for Zhejiang Changhua Auto Parts

Is There Enough Growth For Zhejiang Changhua Auto Parts?

There's an inherent assumption that a company should outperform the market for P/E ratios like Zhejiang Changhua Auto Parts' to be considered reasonable.

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. Whilst it's an improvement, it wasn't enough to get the company out of the hole it was in, with earnings down 13% overall from three years ago. 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 34% 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 Zhejiang Changhua Auto Parts' 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. Only the boldest would assume these prices are sustainable as a continuation of recent earnings trends is likely to weigh heavily on the share price eventually.

What We Can Learn From Zhejiang Changhua Auto Parts' P/E?

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 Zhejiang Changhua Auto Parts 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.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 2 warning signs with Zhejiang Changhua Auto Parts (at least 1 which can't be ignored), and understanding these should be part of your investment process.

You might be able to find a better investment than Zhejiang Changhua Auto Parts. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a P/E below 20x (but have proven they can grow earnings).

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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.