DHC Software Co.,Ltd. (SZSE:002065) Stock Rockets 42% As Investors Are Less Pessimistic Than Expected

Despite an already strong run, DHC Software Co.,Ltd. (SZSE:002065) shares have been powering on, with a gain of 42% in the last thirty days. Taking a wider view, although not as strong as the last month, the full year gain of 23% is also fairly reasonable.

Following the firm bounce in price, DHC SoftwareLtd's price-to-earnings (or "P/E") ratio of 67.7x 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 36x and even P/E's below 21x 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 so lofty.

As an illustration, earnings have deteriorated at DHC SoftwareLtd over the last year, which is not ideal at all. 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.

See our latest analysis for DHC SoftwareLtd

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 DHC SoftwareLtd's earnings, revenue and cash flow.

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

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

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 14%. This means it has also seen a slide in earnings over the longer-term as EPS is down 38% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

In contrast to the company, the rest of the market is expected to grow by 40% over the next year, which really puts the company's recent medium-term earnings decline into perspective.

In light of this, it's alarming that DHC SoftwareLtd'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 Key Takeaway

The strong share price surge has got DHC SoftwareLtd'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.

We've established that DHC SoftwareLtd 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.

Before you settle on your opinion, we've discovered 3 warning signs for DHC SoftwareLtd (1 is a bit concerning!) that you should be aware of.

If you're unsure about the strength of DHC SoftwareLtd's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

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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.