Contact Energy Limited's (NZSE:CEN) Price Is Out Of Tune With Earnings

When close to half the companies in New Zealand have price-to-earnings ratios (or "P/E's") below 18x, you may consider Contact Energy Limited (NZSE:CEN) as a stock to avoid entirely with its 28.2x P/E ratio. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's so lofty.

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Contact Energy 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. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

View our latest analysis for Contact Energy

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Is There Enough Growth For Contact Energy?

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

Taking a look back first, we see that the company grew earnings per share by an impressive 39% last year. Pleasingly, EPS has also lifted 42% in aggregate from three years ago, 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.

Turning to the outlook, the next three years should generate growth of 0.2% each year as estimated by the five analysts watching the company. That's shaping up to be materially lower than the 17% each year growth forecast for the broader market.

In light of this, it's alarming that Contact Energy'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. Only the boldest would assume these prices are sustainable as this level of earnings growth is likely to weigh heavily on the share price eventually.

What We Can Learn From Contact Energy's P/E?

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.

Our examination of Contact Energy's analyst forecasts revealed that its inferior earnings outlook isn't impacting its high P/E anywhere near as much as we would have predicted. 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.

Having said that, be aware Contact Energy is showing 3 warning signs in our investment analysis, and 1 of those is a bit unpleasant.

If these risks are making you reconsider your opinion on Contact Energy, explore our interactive list of high quality stocks to get an idea of what else is out there.

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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.