Wesfarmers Limited's (ASX:WES) Business Is Yet to Catch Up With Its Share Price

Wesfarmers Limited's (ASX:WES) price-to-earnings (or "P/E") ratio of 30.6x might make it look like a strong sell right now compared to the market in Australia, where around half of the companies have P/E ratios below 19x and even P/E's below 11x 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.

Recent times haven't been advantageous for Wesfarmers as its earnings have been rising slower than most other companies. One possibility is that the P/E is high because investors think this lacklustre earnings performance will improve markedly. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

Check out our latest analysis for Wesfarmers

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Is There Enough Growth For Wesfarmers?

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

Retrospectively, the last year delivered a decent 3.6% gain to the company's bottom line. The latest three year period has also seen a 7.1% overall rise in EPS, aided somewhat by its short-term performance. Therefore, it's fair to say the earnings growth recently has been respectable for the company.

Turning to the outlook, the next three years should generate growth of 8.7% per annum as estimated by the analysts watching the company. Meanwhile, the rest of the market is forecast to expand by 18% per annum, which is noticeably more attractive.

In light of this, it's alarming that Wesfarmers' 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

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.

We've established that Wesfarmers currently trades on a much higher than expected P/E since its forecast growth is lower than the wider market. When we see a weak earnings outlook with slower than market growth, 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.

Before you take the next step, you should know about the 2 warning signs for Wesfarmers that we have uncovered.

You might be able to find a better investment than Wesfarmers. 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.