There's Reason For Concern Over ChengDa Pharmaceuticals Co., Ltd.'s (SZSE:301201) Massive 42% Price Jump

The ChengDa Pharmaceuticals Co., Ltd. (SZSE:301201) share price has done very well over the last month, posting an excellent gain of 42%. 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, ChengDa Pharmaceuticals' price-to-earnings (or "P/E") ratio of 43.1x 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 33x and even P/E's below 20x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.

Earnings have risen firmly for ChengDa Pharmaceuticals recently, which is pleasing to see. One possibility is that the P/E is high because investors think this respectable earnings growth will be enough to outperform the broader market in the near future. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

See our latest analysis for ChengDa Pharmaceuticals

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 ChengDa Pharmaceuticals' earnings, revenue and cash flow.

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

ChengDa Pharmaceuticals' P/E ratio would be typical for a company that's expected to deliver solid growth, and importantly, perform better than the market.

Taking a look back first, we see that the company grew earnings per share by an impressive 24% last year. Still, incredibly EPS has fallen 47% in total from three years ago, which is quite disappointing. 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 37% shows it's an unpleasant look.

With this information, we find it concerning that ChengDa Pharmaceuticals 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.

The Key Takeaway

The large bounce in ChengDa Pharmaceuticals' shares has lifted the company's P/E to a fairly high level. 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.

We've established that ChengDa Pharmaceuticals currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. 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.

It is also worth noting that we have found 3 warning signs for ChengDa Pharmaceuticals (2 don't sit too well with us!) that you need to take into consideration.

Of course, you might also be able to find a better stock than ChengDa Pharmaceuticals. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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

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.