When close to half the companies in China have price-to-earnings ratios (or "P/E's") above 30x, you may consider Zhejiang Dahua Technology Co., Ltd. (SZSE:002236) as a highly attractive investment with its 7x P/E ratio. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's so limited.

Zhejiang Dahua Technology certainly has been doing a good job lately as it's been growing earnings more than most other companies. It might be that many expect the strong earnings performance to degrade substantially, which has repressed the P/E. If not, then existing shareholders have reason to be quite optimistic about the future direction of the share price.

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

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

Retrospectively, the last year delivered an exceptional 169% gain to the company's bottom line. Pleasingly, EPS has also lifted 68% in aggregate from three years ago, thanks to the last 12 months of growth. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.

Turning to the outlook, the next three years should bring diminished returns, with earnings decreasing 10% per annum as estimated by the analysts watching the company. Meanwhile, the broader market is forecast to expand by 25% per annum, which paints a poor picture.

With this information, we are not surprised that Zhejiang Dahua Technology is trading at a P/E lower than the market. However, shrinking earnings are unlikely to lead to a stable P/E over the longer term. There's potential for the P/E to fall to even lower levels if the company doesn't improve its profitability.

What We Can Learn From Zhejiang Dahua Technology's P/E?

Using the price-to-earnings ratio alone to determine if you should sell your stock isn't sensible, however it can be a practical guide to the company's future prospects.

We've established that Zhejiang Dahua Technology maintains its low P/E on the weakness of its forecast for sliding earnings, as expected. Right now shareholders are accepting the low P/E as they concede future earnings probably won't provide any pleasant surprises. Unless these conditions improve, they will continue to form a barrier for the share price around these levels.

You need to take note of risks, for example - Zhejiang Dahua Technology has 2 warning signs (and 1 which can't be ignored) we think you should know about.

Of course, you might also be able to find a better stock than Zhejiang Dahua Technology. 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.

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