Shanghai Zhenhua Heavy Industries Co., Ltd.'s (SHSE:600320) price-to-earnings (or "P/E") ratio of 34.9x might make it look like a sell right now compared to the market in China, where around half of the companies have P/E ratios below 30x and even P/E's below 18x are quite common. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's as high as it is.
Shanghai Zhenhua Heavy Industries certainly has been doing a good job lately as it's been growing earnings more than most other companies. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. If not, then existing shareholders might be a little nervous about the viability of the share price.
Does Growth Match The High P/E?
There's an inherent assumption that a company should outperform the market for P/E ratios like Shanghai Zhenhua Heavy Industries' to be considered reasonable.
Taking a look back first, we see that the company grew earnings per share by an impressive 43% last year. The latest three year period has also seen a 23% overall rise in EPS, aided extensively by its short-term performance. Therefore, it's fair to say the earnings growth recently has been respectable for the company.
Shifting to the future, estimates from the only analyst covering the company suggest earnings should grow by 43% each year over the next three years. That's shaping up to be materially higher than the 20% per year growth forecast for the broader market.
With this information, we can see why Shanghai Zhenhua Heavy Industries is trading at such a high P/E compared to the market. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.
The Final Word
Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.
As we suspected, our examination of Shanghai Zhenhua Heavy Industries' analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. Right now shareholders are comfortable with the P/E as they are quite confident future earnings aren't under threat. It's hard to see the share price falling strongly in the near future under these circumstances.
It's always necessary to consider the ever-present spectre of investment risk. We've identified 3 warning signs with Shanghai Zhenhua Heavy Industries, and understanding them should be part of your investment process.
Of course, you might also be able to find a better stock than Shanghai Zhenhua Heavy Industries. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.