Huarong Chemical Co., Ltd.'s (SZSE:301256) 45% Share Price Surge Not Quite Adding Up

The Huarong Chemical Co., Ltd. (SZSE:301256) share price has done very well over the last month, posting an excellent gain of 45%. Longer-term shareholders would be thankful for the recovery in the share price since it's now virtually flat for the year after the recent bounce.

After such a large jump in price, Huarong Chemical's price-to-earnings (or "P/E") ratio of 39.1x might make it look like a sell right now compared to the market in China, where around half of the companies have P/E ratios below 31x and even P/E's below 18x are quite common. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's as high as it is.

For instance, Huarong Chemical's receding earnings in recent times would have to be some food for thought. One possibility is that the P/E is high because investors think the company will still do enough to outperform the broader market in the near future. If not, then existing shareholders may be quite nervous about the viability of the share price.

Check out our latest analysis for Huarong Chemical

We don't have analyst forecasts, but you can see how recent trends are setting up the company for the future by checking out our free report on Huarong Chemical's earnings, revenue and cash flow.

How Is Huarong Chemical's Growth Trending?

There's an inherent assumption that a company should outperform the market for P/E ratios like Huarong Chemical's to be considered reasonable.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 40%. This means it has also seen a slide in earnings over the longer-term as EPS is down 32% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Comparing that to the market, which is predicted to deliver 37% growth in the next 12 months, the company's downward momentum based on recent medium-term earnings results is a sobering picture.

With this information, we find it concerning that Huarong Chemical is trading at a P/E higher than the market. It seems most investors are ignoring the recent poor growth rate and are hoping for a turnaround in the company's business prospects. Only the boldest would assume these prices are sustainable as a continuation of recent earnings trends is likely to weigh heavily on the share price eventually.

What We Can Learn From Huarong Chemical's P/E?

The large bounce in Huarong Chemical's shares has lifted the company's P/E to a fairly high level. Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

We've established that Huarong Chemical currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. Right now we are increasingly uncomfortable with the high P/E as this earnings performance is highly unlikely to support such positive sentiment for long. 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.

We don't want to rain on the parade too much, but we did also find 2 warning signs for Huarong Chemical that you need to be mindful of.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with a strong growth track record, trading on 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.