There's Reason For Concern Over Chongqing Zongshen Power Machinery Co.,Ltd's (SZSE:001696) Massive 42% Price Jump

Chongqing Zongshen Power Machinery Co.,Ltd (SZSE:001696) shares have continued their recent momentum with a 42% gain in the last month alone. Looking back a bit further, it's encouraging to see the stock is up 65% in the last year.

Since its price has surged higher, Chongqing Zongshen Power MachineryLtd's price-to-earnings (or "P/E") ratio of 32.6x might make it look like a sell right now compared to the market in China, where around half of the companies have P/E ratios below 29x and even P/E's below 18x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

For instance, Chongqing Zongshen Power MachineryLtd's receding earnings in recent times would have to be some food for thought. One possibility is that the P/E is high because investors think the company will still do enough to outperform the broader market in the near future. If not, then existing shareholders may be quite nervous about the viability of the share price.

See our latest analysis for Chongqing Zongshen Power MachineryLtd

Although there are no analyst estimates available for Chongqing Zongshen Power MachineryLtd, take a look at this free data-rich visualisation to see how the company stacks up on earnings, revenue and cash flow.

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

In order to justify its P/E ratio, Chongqing Zongshen Power MachineryLtd would need to produce impressive growth in excess of 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 7.5%. This means it has also seen a slide in earnings over the longer-term as EPS is down 38% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Comparing that to the market, which is predicted to deliver 35% growth in the next 12 months, the company's downward momentum based on recent medium-term earnings results is a sobering picture.

With this information, we find it concerning that Chongqing Zongshen Power MachineryLtd is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than recent times would indicate and aren't willing to let go of their stock at any price. 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.

What We Can Learn From Chongqing Zongshen Power MachineryLtd's P/E?

Chongqing Zongshen Power MachineryLtd shares have received a push in the right direction, but its P/E is elevated too. While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.

We've established that Chongqing Zongshen Power MachineryLtd currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. 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. If recent medium-term earnings trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 3 warning signs with Chongqing Zongshen Power MachineryLtd (at least 1 which makes us a bit uncomfortable), and understanding these should be part of your investment process.

You might be able to find a better investment than Chongqing Zongshen Power MachineryLtd. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a low P/E (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.