To the annoyance of some shareholders, Chi Ho Development Holdings (HKG:8423) shares are down a considerable 59% in the last month. That drop has capped off a tough year for shareholders, with the share price down 58% in that time.
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. The implication here is that long term investors have an opportunity when expectations of a company are too low. One way to gauge market expectations of a stock 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 Chi Ho Development Holdings Have A Relatively High Or Low P/E For Its Industry?
Chi Ho Development Holdings's P/E of 19.10 indicates some degree of optimism towards the stock. As you can see below, Chi Ho Development Holdings has a higher P/E than the average company (10.1) in the construction industry.
Its relatively high P/E ratio indicates that Chi Ho Development Holdings shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and 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. Then, a lower P/E should attract more buyers, pushing the share price up.
Chi Ho Development Holdings had pretty flat EPS growth in the last year. But it has grown its earnings per share by 7.4% per year over the last three years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
Chi Ho Development Holdings's Balance Sheet
Chi Ho Development Holdings has net debt worth just 6.5% of its market capitalization. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Bottom Line On Chi Ho Development Holdings's P/E Ratio
Chi Ho Development Holdings trades on a P/E ratio of 19.1, which is above its market average of 10.2. Given the debt is only modest, and earnings are already moving in the right direction, it's not surprising that the market expects continued improvement. Given Chi Ho Development Holdings's P/E ratio has declined from 46.1 to 19.1 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
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. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Chi Ho Development Holdings. 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).
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