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Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. We’ll apply a basic P/E ratio analysis to Watsco, Inc.’s (NYSE:WSO), to help you decide if the stock is worth further research. Based on the last twelve months, Watsco’s P/E ratio is 24.27. That corresponds to an earnings yield of approximately 4.1%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Watsco:
P/E of 24.27 = $158.26 ÷ $6.52 (Based on the trailing twelve months to March 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. 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.
Watsco’s earnings per share grew by -8.8% in the last twelve months. And it has bolstered its earnings per share by 12% per year over the last five years.
Does Watsco Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, Watsco has a higher P/E than the average company (16.4) in the trade distributors industry.
That means that the market expects Watsco will outperform other companies in its industry. The market is optimistic about the future, but that doesn’t guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
Remember: P/E Ratios Don’t Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Watsco’s Balance Sheet
Watsco’s net debt is 4.1% of its market cap. So it doesn’t have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Verdict On Watsco’s P/E Ratio
Watsco’s P/E is 24.3 which is above average (18.3) in the US market. With debt at prudent levels and improving earnings, it’s fair to say the market expects steady progress in the future.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Watsco. 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.