Codan Limited's (ASX:CDA) Shares Climb 27% But Its Business Is Yet to Catch Up

Despite an already strong run, Codan Limited (ASX:CDA) shares have been powering on, with a gain of 27% in the last thirty days. Looking back a bit further, it's encouraging to see the stock is up 90% in the last year.

Since its price has surged higher, Codan's price-to-earnings (or "P/E") ratio of 33.6x 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. However, the P/E might be quite high for a reason and it requires further investigation to determine if it's justified.

With earnings growth that's superior to most other companies of late, Codan has been doing relatively well. 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.

Check out our latest analysis for Codan

Keen to find out how analysts think Codan's future stacks up against the industry? In that case, our free report is a great place to start.

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

Codan's P/E ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the market.

Retrospectively, the last year delivered an exceptional 20% gain to the company's bottom line. However, this wasn't enough as the latest three year period has seen a very unpleasant 10% drop in EPS in aggregate. So unfortunately, we have to acknowledge that the company has not done a great job of growing earnings over that time.

Shifting to the future, estimates from the five analysts covering the company suggest earnings should grow by 19% per year over the next three years. That's shaping up to be similar to the 18% per annum growth forecast for the broader market.

With this information, we find it interesting that Codan is trading at a high P/E compared to the market. It seems most investors are ignoring the fairly average growth expectations and are willing to pay up for exposure to the stock. These shareholders may be setting themselves up for disappointment if the P/E falls to levels more in line with the growth outlook.

The Key Takeaway

The strong share price surge has got Codan's P/E rushing to great heights as well. 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 Codan currently trades on a higher than expected P/E since its forecast growth is only in line with the wider market. When we see an average earnings outlook with market-like growth, we suspect the share price is at risk of declining, sending the high P/E lower. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.

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

If you're unsure about the strength of Codan's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

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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.