When close to half the companies in Hong Kong have price-to-earnings ratios (or "P/E's") below 8x, you may consider China Modern Dairy Holdings Ltd. (HKG:1117) as a stock to avoid entirely with its 25.4x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

While the market has experienced earnings growth lately, China Modern Dairy Holdings' earnings have gone into reverse gear, which is not great. One possibility is that the P/E is high because investors think this poor earnings performance will turn the corner. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Is There Enough Growth For China Modern Dairy Holdings?

The only time you'd be truly comfortable seeing a P/E as steep as China Modern Dairy Holdings' is when the company's growth is on track to outshine the market decidedly.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 69%. This means it has also seen a slide in earnings over the longer-term as EPS is down 82% in total over the last three years. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Turning to the outlook, the next three years should generate growth of 63% per annum as estimated by the six analysts watching the company. With the market only predicted to deliver 15% per year, the company is positioned for a stronger earnings result.

With this information, we can see why China Modern Dairy Holdings 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 Key Takeaway

While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.

As we suspected, our examination of China Modern Dairy Holdings' 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 China Modern Dairy Holdings, and understanding them should be part of your investment process.

If P/E ratios interest you, you may wish to see this free collection of other companies with strong earnings growth and low P/E ratios.

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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.