There wouldn't be many who think Chengzhi Co., Ltd.'s (SZSE:000990) price-to-earnings (or "P/E") ratio of 37.8x is worth a mention when the median P/E in China is similar at about 35x. However, investors might be overlooking a clear opportunity or potential setback if there is no rational basis for the P/E.

Recent times have been pleasing for Chengzhi as its earnings have risen in spite of the market's earnings going into reverse. One possibility is that the P/E is moderate because investors think the company's earnings will be less resilient moving forward. If not, then existing shareholders have reason to be feeling optimistic about the future direction of the share price.

Does Growth Match The P/E?

There's an inherent assumption that a company should be matching the market for P/E ratios like Chengzhi's to be considered reasonable.

Retrospectively, the last year delivered an exceptional 77% gain to the company's bottom line. Despite this strong recent growth, it's still struggling to catch up as its three-year EPS frustratingly shrank by 81% overall. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Looking ahead now, EPS is anticipated to climb by 24% during the coming year according to the one analyst following the company. With the market predicted to deliver 39% growth , the company is positioned for a weaker earnings result.

With this information, we find it interesting that Chengzhi is trading at a fairly similar P/E to the market. Apparently many investors in the company are less bearish than analysts indicate and aren't willing to let go of their stock right now. These shareholders may be setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.

The Final Word

We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

We've established that Chengzhi currently trades on a higher than expected P/E since its forecast growth is lower than the wider market. Right now we are uncomfortable with the P/E as the predicted future earnings aren't likely to support a more positive sentiment for long. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.

Plus, you should also learn about these 2 warning signs we've spotted with Chengzhi.

It's important to make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.