Xuchang Yuandong Drive Shaft Co.Ltd's (SZSE:002406) 25% Share Price Surge Not Quite Adding Up

Xuchang Yuandong Drive Shaft Co.Ltd (SZSE:002406) shares have continued their recent momentum with a 25% gain in the last month alone. Looking back a bit further, it's encouraging to see the stock is up 32% in the last year.

Since its price has surged higher, Xuchang Yuandong Drive ShaftLtd's price-to-earnings (or "P/E") ratio of 55.5x 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 39x and even P/E's below 22x 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.

Xuchang Yuandong Drive ShaftLtd has been doing a good job lately as it's been growing earnings at a solid pace. One possibility is that the P/E is high because investors think this respectable 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.

View our latest analysis for Xuchang Yuandong Drive ShaftLtd

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Does Growth Match The High P/E?

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

Taking a look back first, we see that the company managed to grow earnings per share by a handy 12% last year. Ultimately though, it couldn't turn around the poor performance of the prior period, with EPS shrinking 63% 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.

Comparing that to the market, which is predicted to deliver 37% growth in the next 12 months, the company's downward momentum based on recent medium-term earnings results is a sobering picture.

In light of this, it's alarming that Xuchang Yuandong Drive ShaftLtd'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

The large bounce in Xuchang Yuandong Drive ShaftLtd's shares has lifted the company's P/E to a fairly high level. Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.

We've established that Xuchang Yuandong Drive ShaftLtd currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. When we see earnings heading backwards and underperforming the market forecasts, we suspect the share price is at risk of declining, sending the high P/E lower. 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 3 warning signs we've spotted with Xuchang Yuandong Drive ShaftLtd (including 1 which is potentially serious).

If you're unsure about the strength of Xuchang Yuandong Drive ShaftLtd'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.