To the annoyance of some shareholders, China Health Group (HKG:8225) shares are down a considerable 34% in the last month. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 59% drop over twelve months.
All else being equal, a share price drop should make a stock more attractive to potential investors. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
Does China Health Group Have A Relatively High Or Low P/E For Its Industry?
China Health Group's P/E of 2.79 indicates relatively low sentiment towards the stock. The image below shows that China Health Group has a lower P/E than the average (57.7) P/E for companies in the life sciences industry.
This suggests that market participants think China Health Group will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
China Health Group shrunk earnings per share by 41% over the last year. But over the longer term (3 years), earnings per share have increased by 504%.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does China Health Group's Debt Impact Its P/E Ratio?
The extra options and safety that comes with China Health Group's CN¥459k net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On China Health Group's P/E Ratio
China Health Group's P/E is 2.8 which is below average (10.3) in the HK market. Falling earnings per share are likely to be keeping potential buyers away, the healthy balance sheet means the company retains potential for future growth. If that occurs, the current low P/E could prove to be temporary. Given China Health Group's P/E ratio has declined from 4.2 to 2.8 in the last month, we know for sure that the market is more worried about the business today, than it was back then. For those who prefer invest in growth, this stock apparently offers limited promise, but the deep value investors may find the pessimism around this stock enticing.
When the market is wrong about a stock, it gives savvy investors an opportunity. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
But note: China Health Group may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.