The Dongguang Chemical (HKG:1702) share price has done well in the last month, posting a gain of 41%. The full year gain of 13% is pretty reasonable, too.
All else being equal, a sharp share price increase should make a stock less attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). The implication here is that deep value investors might steer clear when expectations of a company are too high. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
How Does Dongguang Chemical's P/E Ratio Compare To Its Peers?
Dongguang Chemical's P/E of 9.50 indicates some degree of optimism towards the stock. You can see in the image below that the average P/E (6.8) for companies in the chemicals industry is lower than Dongguang Chemical's P/E.
That means that the market expects Dongguang Chemical will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
Dongguang Chemical's earnings made like a rocket, taking off 87% last year.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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).
Is Debt Impacting Dongguang Chemical's P/E?
Dongguang Chemical has net debt worth 11% of its market capitalization. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.
The Verdict On Dongguang Chemical's P/E Ratio
Dongguang Chemical has a P/E of 9.5. That's below the average in the HK market, which is 10.5. The company does have a little debt, and EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low. What we know for sure is that investors are becoming less uncomfortable about Dongguang Chemical's prospects, since they have pushed its P/E ratio from 6.7 to 9.5 over the last month. For those who like to invest in turnarounds, that might mean it's time to put the stock on a watchlist, or research it. But others might consider the opportunity to have passed.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. Although we don't have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
But note: Dongguang Chemical 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).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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