China New Energy Limited's (HKG:1156) Shares Climb 26% But Its Business Is Yet to Catch Up

China New Energy Limited (HKG:1156) shareholders are no doubt pleased to see that the share price has bounced 26% in the last month, although it is still struggling to make up recently lost ground. Looking back a bit further, it's encouraging to see the stock is up 28% in the last year.

Since its price has surged higher, given close to half the companies operating in Hong Kong's Construction industry have price-to-sales ratios (or "P/S") below 0.4x, you may consider China New Energy as a stock to potentially avoid with its 1.1x P/S ratio. However, the P/S might be high for a reason and it requires further investigation to determine if it's justified.

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View our latest analysis for China New Energy

What Does China New Energy's Recent Performance Look Like?

China New Energy certainly has been doing a great job lately as it's been growing its revenue at a really rapid pace. Perhaps the market is expecting future revenue performance to outperform the wider market, which has seemingly got people interested in the stock. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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

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

There's an inherent assumption that a company should outperform the industry for P/S ratios like China New Energy's to be considered reasonable.

Retrospectively, the last year delivered an exceptional 56% gain to the company's top line. However, this wasn't enough as the latest three year period has seen the company endure a nasty 57% drop in revenue in aggregate. So unfortunately, we have to acknowledge that the company has not done a great job of growing revenues over that time.

In contrast to the company, the rest of the industry is expected to grow by 19% over the next year, which really puts the company's recent medium-term revenue decline into perspective.

In light of this, it's alarming that China New Energy's P/S sits above the majority of other companies. 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/S falls to levels more in line with the recent negative growth rates.

The Key Takeaway

China New Energy shares have taken a big step in a northerly direction, but its P/S is elevated as a result. Using the price-to-sales 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 China New Energy currently trades on a much higher than expected P/S since its recent revenues have been in decline over the medium-term. Right now we aren't comfortable with the high P/S as this revenue performance is highly unlikely to support such positive sentiment for long. 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.

We don't want to rain on the parade too much, but we did also find 3 warning signs for China New Energy (1 can't be ignored!) that you need to be mindful of.

Of course, profitable companies with a history of great earnings growth are generally safer bets. 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.