Yunnan Yuntianhua Co., Ltd.'s (SHSE:600096) price-to-earnings (or "P/E") ratio of 7.5x might make it look like a strong buy right now compared to the market in China, where around half of the companies have P/E ratios above 31x and even P/E's above 57x are quite common. However, the P/E might be quite low for a reason and it requires further investigation to determine if it's justified.

Yunnan Yuntianhua could be doing better as its earnings have been going backwards lately while most other companies have been seeing positive earnings growth. The P/E is probably low because investors think this poor earnings performance isn't going to get any better. If you still like the company, you'd be hoping this isn't the case so that you could potentially pick up some stock while it's out of favour.

What Are Growth Metrics Telling Us About The Low P/E?

In order to justify its P/E ratio, Yunnan Yuntianhua would need to produce anemic growth that's substantially trailing the market.

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 22%. Still, the latest three year period has seen an excellent 2,805% overall rise in EPS, in spite of its unsatisfying short-term performance. Accordingly, while they would have preferred to keep the run going, shareholders would probably welcome the medium-term rates of earnings growth.

Turning to the outlook, the next year should generate growth of 13% as estimated by the six analysts watching the company. That's shaping up to be materially lower than the 39% growth forecast for the broader market.

In light of this, it's understandable that Yunnan Yuntianhua's P/E sits below the majority of other companies. It seems most investors are expecting to see limited future growth and are only willing to pay a reduced amount for the stock.

The Key Takeaway

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 Yunnan Yuntianhua maintains its low P/E on the weakness of its forecast growth being lower than the wider market, as expected. At this stage investors feel the potential for an improvement in earnings isn't great enough to justify a higher P/E ratio. Unless these conditions improve, they will continue to form a barrier for the share price around these levels.

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

Of course, you might also be able to find a better stock than Yunnan Yuntianhua. 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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