The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll show how you can use Waterco Limited’s (ASX:WAT) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Waterco’s P/E ratio is 25.42. That is equivalent to an earnings yield of about 3.9%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Waterco:
P/E of 25.42 = A$2 ÷ A$0.079 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each A$1 the company has earned over the last year. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the ‘E’ will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Waterco’s earnings per share fell by 34% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 26%.
How Does Waterco’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (16.3) for companies in the leisure industry is lower than Waterco’s P/E.
Its relatively high P/E ratio indicates that Waterco shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn’t guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
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).
How Does Waterco’s Debt Impact Its P/E Ratio?
Waterco’s net debt is 23% of its market cap. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.
The Verdict On Waterco’s P/E Ratio
Waterco’s P/E is 25.4 which is above average (16.2) in the AU market. With some debt but no EPS growth last year, the market has high expectations of future profits.
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.’ Although we don’t have analyst forecasts, you might want to assess this data-rich visualization of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Waterco. 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 firstname.lastname@example.org. 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.