Chinasoft International Limited (HKG:354) shareholders would be excited to see that the share price has had a great month, posting a 27% gain and recovering from prior weakness. The last 30 days bring the annual gain to a very sharp 35%.

Following the firm bounce in price, given close to half the companies in Hong Kong have price-to-earnings ratios (or "P/E's") below 10x, you may consider Chinasoft International as a stock to avoid entirely with its 22.8x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

Recent times have been advantageous for Chinasoft International 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. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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Does Growth Match The High P/E?

In order to justify its P/E ratio, Chinasoft International would need to produce outstanding growth well in excess of the market.

Taking a look back first, we see that the company grew earnings per share by an impressive 30% last year. Still, incredibly EPS has fallen 36% in total from three years ago, which is quite disappointing. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Shifting to the future, estimates from the ten analysts covering the company suggest earnings should grow by 19% per annum over the next three years. With the market only predicted to deliver 12% each year, the company is positioned for a stronger earnings result.

With this information, we can see why Chinasoft International is trading at such a high P/E compared to the market. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Final Word

Shares in Chinasoft International have built up some good momentum lately, which has really inflated its P/E. Using the price-to-earnings 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 Chinasoft International maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. It's hard to see the share price falling strongly in the near future under these circumstances.

The company's balance sheet is another key area for risk analysis. Our free balance sheet analysis for Chinasoft International with six simple checks will allow you to discover any risks that could be an issue.

If these risks are making you reconsider your opinion on Chinasoft International, explore our interactive list of high quality stocks to get an idea of what else is out there.

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