Contact Energy Limited's (NZSE:CEN) price-to-earnings (or "P/E") ratio of 35.6x might make it look like a strong sell right now compared to the market in New Zealand, where around half of the companies have P/E ratios below 22x and even P/E's below 12x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.
Contact Energy has been struggling lately as its earnings have declined faster than most other companies. One possibility is that the P/E is high because investors think the company will turn things around completely and accelerate past most others in the market. If not, then existing shareholders may be very nervous about the viability of the share price.
Keen to find out how analysts think Contact Energy's future stacks up against the industry? In that case, our free report is a great place to start.
Is There Enough Growth For Contact Energy?
The only time you'd be truly comfortable seeing a P/E as steep as Contact Energy's 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 26%. As a result, earnings from three years ago have also fallen 3.4% overall. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.
Turning to the outlook, the next three years should bring diminished returns, with earnings decreasing 17% per year as estimated by the six analysts watching the company. That's not great when the rest of the market is expected to grow by 10% per year.
In light of this, it's alarming that Contact Energy's P/E sits above the majority of other companies. Apparently many investors in the company reject the analyst cohort's pessimism and aren't willing to let go of their stock at any price. There's a very good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the negative growth outlook.
The Final Word
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.
Our examination of Contact Energy's analyst forecasts revealed that its outlook for shrinking earnings isn't impacting its high P/E anywhere near as much as we would have predicted. When we see a poor outlook with earnings heading backwards, we suspect the share price is at risk of declining, sending the high P/E lower. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.
We don't want to rain on the parade too much, but we did also find 3 warning signs for Contact Energy (2 are significant!) that you need to be mindful of.
If P/E ratios interest you, you may wish to see this free collection of other companies that have grown earnings strongly and trade on P/E's below 20x.
This article by Simply Wall St is general in nature. 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.
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