Contact Energy Limited's (NZSE:CEN) Share Price Could Signal Some Risk

With a price-to-earnings (or "P/E") ratio of 32.1x Contact Energy Limited (NZSE:CEN) may be sending very bearish signals at the moment, given that almost half of all companies in New Zealand have P/E ratios under 18x and even P/E's lower than 14x are not unusual. 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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Recent times haven't been advantageous for Contact Energy as its earnings have been falling quicker than most other companies. One possibility is that the P/E is high because investors think the company will turn things around completely and accelerate past most others in the market. If not, then existing shareholders may be very nervous about the viability of the share price.

See our latest analysis for Contact Energy

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

Does Growth Match The High P/E?

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

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 22%. This means it has also seen a slide in earnings over the longer-term as EPS is down 12% in total over the last three years. Accordingly, shareholders would have felt downbeat about the medium-term rates of earnings growth.

Looking ahead now, EPS is anticipated to climb by 12% per annum during the coming three years according to the five analysts following the company. That's shaping up to be materially lower than the 18% each year growth forecast for the broader market.

With this information, we find it concerning that Contact Energy is trading at a P/E higher than the market. 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 Final Word

It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

We've established that Contact Energy 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. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

And what about other risks? Every company has them, and we've spotted 3 warning signs for Contact Energy (of which 1 makes us a bit uncomfortable!) you should know about.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with a strong growth track record, trading on a low P/E.

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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.