Zhong Hua International Holdings (HKG:1064) shareholders are no doubt pleased to see that the share price has had a great month, posting a 86% gain, recovering from prior weakness. And the full year gain of 36% isn't too shabby, either!
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 implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
Does Zhong Hua International Holdings Have A Relatively High Or Low P/E For Its Industry?
Zhong Hua International Holdings's P/E of 11.95 indicates some degree of optimism towards the stock. The image below shows that Zhong Hua International Holdings has a higher P/E than the average (6.9) P/E for companies in the real estate industry.
Zhong Hua International Holdings's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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
When earnings fall, the 'E' decreases, over time. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Zhong Hua International Holdings shrunk earnings per share by 33% over the last year. And it has shrunk its earnings per share by 10% per year over the last five years. This growth rate might warrant a below average P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 Zhong Hua International Holdings's Debt Impact Its P/E Ratio?
Since Zhong Hua International Holdings holds net cash of HK$5.8m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Zhong Hua International Holdings's P/E Ratio
Zhong Hua International Holdings trades on a P/E ratio of 11.9, which is above its market average of 10.6. The recent drop in earnings per share might keep 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 is very clear is that the market has become significantly more optimistic about Zhong Hua International Holdings over the last month, with the P/E ratio rising from 6.4 back then to 11.9 today. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.
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. Although we don't have analyst forecasts you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Zhong Hua International Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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