A Rising Share Price Has Us Looking Closely At MECOM Power and Construction Limited’s (HKG:1183) P/E Ratio

MECOM Power and Construction (HKG:1183) shares have had a really impressive month, gaining 36%, after some slippage. The full year gain of 17% is pretty reasonable, too.

All else being equal, a sharp share price increase should make a stock less attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). So some would prefer to hold off buying when there is a lot of optimism towards a stock. Perhaps the simplest way to get a read on investors’ expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.

View our latest analysis for MECOM Power and Construction

Does MECOM Power and Construction Have A Relatively High Or Low P/E For Its Industry?

We can tell from its P/E ratio of 38.47 that there is some investor optimism about MECOM Power and Construction. As you can see below, MECOM Power and Construction has a much higher P/E than the average company (10.2) in the construction industry.

SEHK:1183 Price Estimation Relative to Market, December 16th 2019
SEHK:1183 Price Estimation Relative to Market, December 16th 2019

Its relatively high P/E ratio indicates that MECOM Power and Construction shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn’t guarantee future growth. So further research is always essential. I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

MECOM Power and Construction’s earnings per share fell by 49% in the last twelve months. And over the longer term (5 years) earnings per share have decreased 16% annually. This might lead to muted expectations.

Remember: P/E Ratios Don’t Consider The Balance Sheet

The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

How Does MECOM Power and Construction’s Debt Impact Its P/E Ratio?

With net cash of MO$270m, MECOM Power and Construction has a very strong balance sheet, which may be important for its business. Having said that, at 19% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On MECOM Power and Construction’s P/E Ratio

MECOM Power and Construction trades on a P/E ratio of 38.5, which is multiples above its market average of 10.3. Falling earnings per share is probably keeping traditional value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls. What we know for sure is that investors have become much more excited about MECOM Power and Construction recently, since they have pushed its P/E ratio from 28.3 to 38.5 over the last month. For those who prefer to invest with the flow of momentum, that might mean it’s time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine. We don’t have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

You might be able to find a better buy than MECOM Power and Construction. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.