With a price-to-earnings (or "P/E") ratio of 12.8x NetEase, Inc. (HKG:9999) may be sending bearish signals at the moment, given that almost half of all companies in Hong Kong have P/E ratios under 9x and even P/E's lower than 5x are not unusual. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's as high as it is.

Recent times have been advantageous for NetEase as its earnings have been rising faster than most other companies. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. If not, then existing shareholders might be a little nervous about the viability of the share price.

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

In order to justify its P/E ratio, NetEase would need to produce impressive growth in excess of the market.

If we review the last year of earnings growth, the company posted a worthy increase of 13%. Ultimately though, it couldn't turn around the poor performance of the prior period, with EPS shrinking 50% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Shifting to the future, estimates from the analysts covering the company suggest earnings growth is heading into negative territory, declining 36% per year over the next three years. Meanwhile, the broader market is forecast to expand by 12% per annum, which paints a poor picture.

With this information, we find it concerning that NetEase is trading at a P/E higher than the market. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. Only the boldest would assume these prices are sustainable as these declining earnings are likely to weigh heavily on the share price eventually.

The Final Word

Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

We've established that NetEase currently trades on a much higher than expected P/E for a company whose earnings are forecast to decline. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings are highly unlikely to support such positive sentiment for long. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

Having said that, be aware NetEase is showing 1 warning sign in our investment analysis, you should know about.

Of course, you might also be able to find a better stock than NetEase. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.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.