Why Investors Shouldn't Be Surprised By China Modern Dairy Holdings Ltd.'s (HKG:1117) 27% Share Price Surge

China Modern Dairy Holdings Ltd. (HKG:1117) shareholders would be excited to see that the share price has had a great month, posting a 27% gain and recovering from prior weakness. Not all shareholders will be feeling jubilant, since the share price is still down a very disappointing 14% in the last twelve months.

Following the firm bounce in price, China Modern Dairy Holdings may be sending very bearish signals at the moment with a price-to-earnings (or "P/E") ratio of 34x, since almost half of all companies in Hong Kong have P/E ratios under 9x and even P/E's lower than 5x are not unusual. 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.

China Modern Dairy Holdings hasn't been tracking well recently as its declining earnings compare poorly to other companies, which have seen some growth on average. It might be that many expect the dour earnings performance to recover substantially, which has kept the P/E from collapsing. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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Does Growth Match The High P/E?

The only time you'd be truly comfortable seeing a P/E as steep as China Modern Dairy Holdings' is when the company's growth is on track to outshine the market decidedly.

Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 69%. This means it has also seen a slide in earnings over the longer-term as EPS is down 82% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.

Shifting to the future, estimates from the seven analysts covering the company suggest earnings should grow by 63% per annum over the next three years. With the market only predicted to deliver 16% per annum, the company is positioned for a stronger earnings result.

With this information, we can see why China Modern Dairy Holdings is trading at such a high P/E compared to the market. Apparently shareholders aren't keen to offload something that is potentially eyeing a more prosperous future.

The Key Takeaway

The strong share price surge has got China Modern Dairy Holdings' P/E rushing to great heights as well. It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

We've established that China Modern Dairy Holdings maintains its high P/E on the strength of its forecast growth being higher than the wider market, as expected. Right now shareholders are comfortable with the P/E as they are quite confident future earnings aren't under threat. Unless these conditions change, they will continue to provide strong support to the share price.

And what about other risks? Every company has them, and we've spotted 3 warning signs for China Modern Dairy Holdings you should know about.

If these risks are making you reconsider your opinion on China Modern Dairy Holdings, explore our interactive list of high quality stocks to get an idea of what else is out there.

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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.