With a price-to-earnings (or "P/E") ratio of 41.9x Xiaomi Corporation (HKG:1810) may be sending very bearish signals at the moment, given that almost half of all companies in Hong Kong have P/E ratios under 11x and even P/E's lower than 7x 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.
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Recent times have been advantageous for Xiaomi as its earnings have been rising faster than most other companies. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. If not, then existing shareholders might be a little nervous about the viability of the share price.
Check out our latest analysis for Xiaomi
There's an inherent assumption that a company should far outperform the market for P/E ratios like Xiaomi's to be considered reasonable.
Retrospectively, the last year delivered an exceptional 75% gain to the company's bottom line. The strong recent performance means it was also able to grow EPS by 178% in total over the last three years. So we can start by confirming that the company has done a great job of growing earnings over that time.
Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 29% each year over the next three years. Meanwhile, the rest of the market is forecast to only expand by 15% per year, which is noticeably less attractive.
With this information, we can see why Xiaomi 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.
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.
As we suspected, our examination of Xiaomi's analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. 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.
A lot of potential risks can sit within a company's balance sheet. You can assess many of the main risks through our free balance sheet analysis for Xiaomi with six simple checks.
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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