Linhai Co.,Ltd. (SHSE:600099) shareholders are no doubt pleased to see that the share price has bounced 25% in the last month, although it is still struggling to make up recently lost ground. Not all shareholders will be feeling jubilant, since the share price is still down a very disappointing 10% in the last twelve months.

Since its price has surged higher, when almost half of the companies in China's Auto industry have price-to-sales ratios (or "P/S") below 1.9x, you may consider LinhaiLtd as a stock probably not worth researching with its 2.5x P/S ratio. However, the P/S might be high for a reason and it requires further investigation to determine if it's justified.

How LinhaiLtd Has Been Performing

For example, consider that LinhaiLtd's financial performance has been poor lately as its revenue has been in decline. Perhaps the market believes the company can do enough to outperform the rest of the industry in the near future, which is keeping the P/S ratio high. However, if this isn't the case, investors might get caught out paying too much for the stock.

Is There Enough Revenue Growth Forecasted For LinhaiLtd?

The only time you'd be truly comfortable seeing a P/S as high as LinhaiLtd's is when the company's growth is on track to outshine the industry.

In reviewing the last year of financials, we were disheartened to see the company's revenues fell to the tune of 10%. This has soured the latest three-year period, which nevertheless managed to deliver a decent 26% overall rise in revenue. So we can start by confirming that the company has generally done a good job of growing revenue over that time, even though it had some hiccups along the way.

This is in contrast to the rest of the industry, which is expected to grow by 68% over the next year, materially higher than the company's recent medium-term annualised growth rates.

With this information, we find it concerning that LinhaiLtd is trading at a P/S higher than the industry. It seems most investors are ignoring the fairly limited recent growth rates and are hoping for a turnaround in the company's business prospects. 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 Final Word

The large bounce in LinhaiLtd's shares has lifted the company's P/S handsomely. Typically, we'd caution against reading too much into price-to-sales ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

Our examination of LinhaiLtd 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 observe slower-than-industry revenue growth alongside a high P/S ratio, we assume there to be a significant risk of the share price decreasing, which would result in a lower P/S ratio. Unless there is a significant improvement in the company's medium-term performance, it will be difficult to prevent the P/S ratio from declining to a more reasonable level.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 1 warning sign with LinhaiLtd, and understanding should be part of your investment process.

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.