Success Dragon International Holdings Limited (HKG:1182) shares have had a horrible month, losing 36% after a relatively good period beforehand. Still, a bad month hasn't completely ruined the past year with the stock gaining 80%, which is great even in a bull market.

Even after such a large drop in price, given around half the companies in Hong Kong have price-to-earnings ratios (or "P/E's") below 12x, you may still consider Success Dragon International Holdings as a stock to potentially avoid with its 18x P/E ratio. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

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With earnings growth that's exceedingly strong of late, Success Dragon International Holdings has been doing very well. The P/E is probably high because investors think this strong earnings growth will be enough to outperform the broader market in the near future. If not, then existing shareholders might be a little nervous about the viability of the share price.

View our latest analysis for Success Dragon International Holdings

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 Success Dragon International Holdings' earnings, revenue and cash flow.

How Is Success Dragon International Holdings' Growth Trending?

Success Dragon International Holdings' P/E ratio would be typical for a company that's expected to deliver solid growth, and importantly, perform better than the market.

If we review the last year of earnings growth, the company posted a terrific increase of 38%. The latest three year period has also seen an excellent 32% overall rise in EPS, aided by its short-term performance. Therefore, it's fair to say the earnings growth recently has been superb for the company.

Weighing that recent medium-term earnings trajectory against the broader market's one-year forecast for expansion of 19% shows it's noticeably less attractive on an annualised basis.

With this information, we find it concerning that Success Dragon International Holdings 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 good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with recent growth rates.

The Final Word

There's still some solid strength behind Success Dragon International Holdings' P/E, if not its share price lately. We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

We've established that Success Dragon International Holdings currently trades on a much higher than expected P/E since its recent three-year growth is lower than the wider market forecast. When we see weak earnings with slower than market growth, we suspect the share price is at risk of declining, sending the high P/E lower. 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 Success Dragon International Holdings (at least 2 which make us uncomfortable), and understanding these should be part of your investment process.

If you're unsure about the strength of Success Dragon International Holdings' 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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