Hua Hong Semiconductor (HKG:1347) shareholders are no doubt pleased to see that the share price has had a great month, posting a 34% gain, recovering from prior weakness. The full year gain of 40% is pretty reasonable, too.
All else being equal, a sharp share price increase should make a stock less 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. The implication here is that deep value investors might steer clear when expectations of a company are too high. 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 ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
Does Hua Hong Semiconductor Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 16.05 that there is some investor optimism about Hua Hong Semiconductor. You can see in the image below that the average P/E (14.7) for companies in the semiconductor industry is lower than Hua Hong Semiconductor's P/E.
That means that the market expects Hua Hong Semiconductor will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. 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.
Hua Hong Semiconductor saw earnings per share decrease by 13% last year. But it has grown its earnings per share by 5.8% per year over the last five years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
How Does Hua Hong Semiconductor's Debt Impact Its P/E Ratio?
With net cash of US$1.1b, Hua Hong Semiconductor has a very strong balance sheet, which may be important for its business. Having said that, at 35% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Hua Hong Semiconductor's P/E Ratio
Hua Hong Semiconductor trades on a P/E ratio of 16.0, which is above its market average of 10.6. Falling earnings per share is probably keeping traditional value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls. What we know for sure is that investors have become more excited about Hua Hong Semiconductor recently, since they have pushed its P/E ratio from 12.0 to 16.0 over the last month. If you like to buy stocks that have recently impressed the market, then this one might be a candidate; but if you prefer to invest when there is 'blood in the streets', then you may feel the opportunity has passed.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Hua Hong Semiconductor. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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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