What Cathay Biotech Inc.'s (SHSE:688065) 27% Share Price Gain Is Not Telling You

Cathay Biotech Inc. (SHSE:688065) shares have had a really impressive month, gaining 27% after a shaky period beforehand. While recent buyers may be laughing, long-term holders might not be as pleased since the recent gain only brings the stock back to where it started a year ago.

Following the firm bounce in price, Cathay Biotech's price-to-earnings (or "P/E") ratio of 76.4x might make it look like a strong sell right now compared to the market in China, where around half of the companies have P/E ratios below 32x and even P/E's below 20x are quite common. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

For instance, Cathay Biotech's receding earnings in recent times would have to be some food for thought. It might be that many expect the company to still outplay most other companies over the coming period, which has kept the P/E from collapsing. If not, then existing shareholders may be quite nervous about the viability of the share price.

Check out our latest analysis for Cathay Biotech

Although there are no analyst estimates available for Cathay Biotech, take a look at this free data-rich visualisation to see how the company stacks up on earnings, revenue and cash flow.

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

In order to justify its P/E ratio, Cathay Biotech would need to produce outstanding growth well in excess of the market.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 5.6%. This means it has also seen a slide in earnings over the longer-term as EPS is down 17% in total over the last three years. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Weighing that medium-term earnings trajectory against the broader market's one-year forecast for expansion of 39% shows it's an unpleasant look.

In light of this, it's alarming that Cathay Biotech's P/E sits above the majority of other companies. Apparently many investors in the company are way more bullish than recent times would indicate and aren't willing to let go of their stock at any price. There's a very good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the recent negative growth rates.

The Final Word

The strong share price surge has got Cathay Biotech's P/E rushing to great heights as well. 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.

Our examination of Cathay Biotech revealed its shrinking earnings over the medium-term aren't impacting its high P/E anywhere near as much as we would have predicted, given the market is set to grow. When we see earnings heading backwards and underperforming the market forecasts, we suspect the share price is at risk of declining, sending the high P/E lower. If recent medium-term earnings trends continue, it will place shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

There are also other vital risk factors to consider before investing and we've discovered 1 warning sign for Cathay Biotech that you should be aware of.

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).

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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.