Risks To Shareholder Returns Are Elevated At These Prices For Cochlear Limited (ASX:COH)

When close to half the companies in Australia have price-to-earnings ratios (or "P/E's") below 21x, you may consider Cochlear Limited (ASX:COH) as a stock to avoid entirely with its 45.8x P/E ratio. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

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There hasn't been much to differentiate Cochlear's and the market's earnings growth lately. It might be that many expect the mediocre earnings performance to strengthen positively, which has kept the P/E from falling. If not, then existing shareholders may be a little nervous about the viability of the share price.

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

In order to justify its P/E ratio, Cochlear would need to produce outstanding growth well in excess of the market.

Taking a look back first, we see that the company managed to grow earnings per share by a handy 9.2% last year. Pleasingly, EPS has also lifted 35% in aggregate from three years ago, partly thanks to the last 12 months of growth. So we can start by confirming that the company has done a great job of growing earnings over that time.

Looking ahead now, EPS is anticipated to climb by 15% per year during the coming three years according to the analysts following the company. Meanwhile, the rest of the market is forecast to expand by 19% per annum, which is noticeably more attractive.

In light of this, it's alarming that Cochlear's P/E sits above the majority of other companies. 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 Key Takeaway

While the price-to-earnings ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of earnings expectations.

We've established that Cochlear 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. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

Many other vital risk factors can be found on the company's balance sheet. Take a look at our free balance sheet analysis for Cochlear with six simple checks on some of these key factors.

Of course, you might also be able to find a better stock than Cochlear. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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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.