Challenger Limited's (ASX:CGF) Price In Tune With Earnings

When close to half the companies in Australia have price-to-earnings ratios (or "P/E's") below 17x, you may consider Challenger Limited (ASX:CGF) as a stock to avoid entirely with its 28.5x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.

While the market has experienced earnings growth lately, Challenger's earnings have gone into reverse gear, which is not great. One possibility is that the P/E is high because investors think this poor earnings performance will turn the corner. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

See our latest analysis for Challenger

If you'd like to see what analysts are forecasting going forward, you should check out our free report on Challenger.

Does Growth Match The High P/E?

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

Retrospectively, the last year delivered a frustrating 27% decrease to the company's bottom line. The last three years don't look nice either as the company has shrunk EPS by 78% in aggregate. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Looking ahead now, EPS is anticipated to climb by 48% per annum during the coming three years according to the twelve analysts following the company. Meanwhile, the rest of the market is forecast to only expand by 15% each year, which is noticeably less attractive.

In light of this, it's understandable that Challenger's P/E sits above the majority of other companies. It seems most investors are expecting this strong future growth and are willing to pay more for the stock.

The Final Word

Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

As we suspected, our examination of Challenger's analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. It's hard to see the share price falling strongly in the near future under these circumstances.

You should always think about risks. Case in point, we've spotted 3 warning signs for Challenger you should be aware of.

If P/E ratios interest you, you may wish to see this free collection of other companies with strong earnings growth and low P/E ratios.

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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.