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Should You Be Tempted To Sell Contact Energy Limited (NZSE:CEN) Because Of Its P/E Ratio?

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Contact Energy Limited's (NZSE:CEN) P/E ratio could help you assess the value on offer. What is Contact Energy's P/E ratio? Well, based on the last twelve months it is 33.9. That corresponds to an earnings yield of approximately 2.9%.

Check out our latest analysis for Contact Energy

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Contact Energy:

P/E of 33.9 = NZ$7.77 ÷ NZ$0.23 (Based on the year to December 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each NZ$1 of company earnings. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'

How Does Contact Energy's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Contact Energy has a higher P/E than the average (30.5) P/E for companies in the electric utilities industry.

NZSE:CEN Price Estimation Relative to Market, August 1st 2019
NZSE:CEN Price Estimation Relative to Market, August 1st 2019

Contact Energy's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.

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Contact Energy's 105% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Regrettably, the longer term performance is poor, with EPS down 5.4% per year over 5 years.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

So What Does Contact Energy's Balance Sheet Tell Us?

Contact Energy has net debt worth 18% of its market capitalization. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.

The Bottom Line On Contact Energy's P/E Ratio

Contact Energy trades on a P/E ratio of 33.9, which is above its market average of 17.9. While the company does use modest debt, its recent earnings growth is superb. So on this analysis a high P/E ratio seems reasonable.

When the market is wrong about a stock, it gives savvy investors an opportunity. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course you might be able to find a better stock than Contact Energy. So you may wish to see this free collection of other companies that have grown earnings strongly.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.