Some Confidence Is Lacking In Essence Fastening Systems (Shanghai) Co., Ltd.'s (SZSE:301005) P/S

When close to half the companies in the Auto Components industry in China have price-to-sales ratios (or "P/S") below 2.8x, you may consider Essence Fastening Systems (Shanghai) Co., Ltd. (SZSE:301005) as a stock to avoid entirely with its 7x 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.

Check out our latest analysis for Essence Fastening Systems (Shanghai)

What Does Essence Fastening Systems (Shanghai)'s Recent Performance Look Like?

Revenue has risen firmly for Essence Fastening Systems (Shanghai) recently, which is pleasing to see. 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.

We don't have analyst forecasts, but you can see how recent trends are setting up the company for the future by checking out our free report on Essence Fastening Systems (Shanghai)'s earnings, revenue and cash flow.

Do Revenue Forecasts Match The High P/S Ratio?

There's an inherent assumption that a company should far outperform the industry for P/S ratios like Essence Fastening Systems (Shanghai)'s to be considered reasonable.

If we review the last year of revenue growth, the company posted a terrific increase of 28%. Pleasingly, revenue has also lifted 49% in aggregate from three years ago, thanks to the last 12 months of growth. Therefore, it's fair to say the revenue growth recently has been superb for the company.

Comparing that to the industry, which is predicted to deliver 25% growth in the next 12 months, the company's momentum is weaker, based on recent medium-term annualised revenue results.

With this information, we find it concerning that Essence Fastening Systems (Shanghai) is trading at a P/S higher than the industry. 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 good chance existing shareholders are setting themselves up for future disappointment if the P/S falls to levels more in line with recent growth rates.

The Key Takeaway

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 Essence Fastening Systems (Shanghai) 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 see slower than industry revenue growth but an elevated P/S, there's considerable risk of the share price declining, sending the P/S lower. If recent medium-term revenue trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

You should always think about risks. Case in point, we've spotted 3 warning signs for Essence Fastening Systems (Shanghai) you should be aware of, and 1 of them makes us a bit uncomfortable.

If you're unsure about the strength of Essence Fastening Systems (Shanghai)'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.