Cogstate Limited (ASX:CGS) Stock Rockets 27% As Investors Are Less Pessimistic Than Expected

The Cogstate Limited (ASX:CGS) share price has done very well over the last month, posting an excellent gain of 27%. Not all shareholders will be feeling jubilant, since the share price is still down a very disappointing 12% in the last twelve months.

Since its price has surged higher, Cogstate's price-to-earnings (or "P/E") ratio of 24.3x might make it look like a sell right now compared to the market in Australia, where around half of the companies have P/E ratios below 20x and even P/E's below 11x are quite common. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.

Cogstate certainly has been doing a good job lately as it's been growing earnings more than most other companies. The P/E is probably high because investors think this strong earnings performance will continue. If not, then existing shareholders might be a little nervous about the viability of the share price.

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Is There Enough Growth For Cogstate?

The only time you'd be truly comfortable seeing a P/E as high as Cogstate's is when the company's growth is on track to outshine the market.

If we review the last year of earnings growth, the company posted a terrific increase of 54%. However, the latest three year period hasn't been as great in aggregate as it didn't manage to provide any growth at all. Accordingly, shareholders probably wouldn't have been overly satisfied with the unstable medium-term growth rates.

Looking ahead now, EPS is anticipated to slump, contracting by 8.7% during the coming year according to the one analyst following the company. Meanwhile, the broader market is forecast to expand by 25%, which paints a poor picture.

With this information, we find it concerning that Cogstate is trading at a P/E higher than the market. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. 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.

What We Can Learn From Cogstate's P/E?

The large bounce in Cogstate's shares has lifted the company's P/E to a fairly high level. Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

Our examination of Cogstate'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. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

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 Cogstate with six simple checks.

You might be able to find a better investment than Cogstate. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a low P/E (but have proven they can grow earnings).

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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.