To the annoyance of some shareholders, Zhonghua Gas Holdings (HKG:8246) shares are down a considerable 47% in the last month. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 59% drop over twelve months.
All else being equal, a share price drop should make a stock more 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 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 Zhonghua Gas Holdings Have A Relatively High Or Low P/E For Its Industry?
Zhonghua Gas Holdings's P/E of 5.22 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (10.3) for companies in the construction industry is higher than Zhonghua Gas Holdings's P/E.
Zhonghua Gas Holdings's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, 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. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
In the last year, Zhonghua Gas Holdings grew EPS like Taylor Swift grew her fan base back in 2010; the 58% gain was both fast and well deserved. And earnings per share have improved by 25% annually, over the last three years. So you might say it really deserves to have an above-average P/E ratio.
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. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Is Debt Impacting Zhonghua Gas Holdings's P/E?
Since Zhonghua Gas Holdings holds net cash of CN¥59m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Zhonghua Gas Holdings's P/E Ratio
Zhonghua Gas Holdings has a P/E of 5.2. That's below the average in the HK market, which is 10.5. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The below average P/E ratio suggests that market participants don't believe the strong growth will continue. Given Zhonghua Gas Holdings's P/E ratio has declined from 9.9 to 5.2 in the last month, we know for sure that the market is more worried 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 deep value investors this stock might justify some research.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. We don't have analyst forecasts, but you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
But note: Zhonghua Gas 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).
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