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A Rising Share Price Has Us Looking Closely At China ZhongDi Dairy Holdings Company Limited's (HKG:1492) P/E Ratio

Simply Wall St

China ZhongDi Dairy Holdings (HKG:1492) shares have had a really impressive month, gaining 32%, after some slippage. But shareholders may not all be feeling jubilant, since the share price is still down 18% in the last year.

Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. 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 some would prefer to hold off buying when there is a lot of optimism towards a stock. 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.

View our latest analysis for China ZhongDi Dairy Holdings

How Does China ZhongDi Dairy Holdings's P/E Ratio Compare To Its Peers?

We can tell from its P/E ratio of 13.60 that sentiment around China ZhongDi Dairy Holdings isn't particularly high. The image below shows that China ZhongDi Dairy Holdings has a lower P/E than the average (15.7) P/E for companies in the food industry.

SEHK:1492 Price Estimation Relative to Market, January 2nd 2020

China ZhongDi Dairy Holdings's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

China ZhongDi Dairy Holdings saw earnings per share decrease by 17% last year. And over the longer term (5 years) earnings per share have decreased 16% annually. This might lead to muted expectations.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. 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 China ZhongDi Dairy Holdings's Debt Impact Its P/E Ratio?

Net debt totals a substantial 172% of China ZhongDi Dairy Holdings's market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.

The Verdict On China ZhongDi Dairy Holdings's P/E Ratio

China ZhongDi Dairy Holdings has a P/E of 13.6. That's higher than the average in its market, which is 10.6. With significant debt and no EPS growth last year, shareholders are betting on an improvement in earnings from the company. What we know for sure is that investors have become more excited about China ZhongDi Dairy Holdings recently, since they have pushed its P/E ratio from 10.3 to 13.6 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. 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 shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

But note: China ZhongDi Dairy Holdings 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 editorial-team@simplywallst.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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.