Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we’ll show how American Water Works Company, Inc.’s (NYSE:AWK) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, American Water Works Company has a P/E ratio of 33.12. That means that at current prices, buyers pay $33.12 for every $1 in trailing yearly profits.
How Do You Calculate American Water Works Company’s P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for American Water Works Company:
P/E of 33.12 = $104.32 ÷ $3.15 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It’s nice to see that American Water Works Company grew EPS by a stonking 32% in the last year. And its annual EPS growth rate over 5 years is 8.6%. I’d therefore be a little surprised if its P/E ratio was not relatively high.
Does American Water Works Company Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. As you can see below American Water Works Company has a P/E ratio that is fairly close for the average for the water utilities industry, which is 33.8.
Its P/E ratio suggests that American Water Works Company shareholders think that in the future it will perform about the same as other companies in its industry classification. The company could surprise by performing better than average, in the future. Further research into factors such asmanagement tenure, could help you form your own view on whether that is likely.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn’t take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does American Water Works Company’s Debt Impact Its P/E Ratio?
Net debt is 45% of American Water Works Company’s market cap. While it’s worth keeping this in mind, it isn’t a worry.
The Verdict On American Water Works Company’s P/E Ratio
American Water Works Company’s P/E is 33.1 which is above average (18.1) in the US market. While the company does use modest debt, its recent earnings growth is superb. So to be frank we are not surprised it has a high P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than American Water Works Company. So you may wish to see this free collection of other companies that have grown earnings strongly.
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If you spot an error that warrants correction, please contact the editor at email@example.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.