Some Shareholders Feeling Restless Over Coles Group Limited's (ASX:COL) P/E Ratio

When close to half the companies in Australia have price-to-earnings ratios (or "P/E's") below 18x, you may consider Coles Group Limited (ASX:COL) as a stock to potentially avoid with its 26x P/E ratio. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

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Recent times have been advantageous for Coles Group as its earnings have been rising faster than most other companies. The P/E is probably high because investors think this strong earnings performance will continue. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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

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

Retrospectively, the last year delivered a decent 8.5% gain to the company's bottom line. The solid recent performance means it was also able to grow EPS by 11% in total over the last three years. Therefore, it's fair to say the earnings growth recently has been respectable for the company.

Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 7.6% per year over the next three years. Meanwhile, the rest of the market is forecast to expand by 15% per year, which is noticeably more attractive.

With this information, we find it concerning that Coles Group is trading at a P/E higher than the market. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.

The Bottom Line On Coles Group's P/E

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 Coles Group currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings aren't likely to support such positive sentiment for long. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

It's always necessary to consider the ever-present spectre of investment risk. We've identified 2 warning signs with Coles Group, and understanding them should be part of your investment process.

If these risks are making you reconsider your opinion on Coles Group, 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.