The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
California Water Service Group (NYSE:CWT) is currently trading at a trailing P/E of 34.6, which is higher than the industry average of 30.2. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for CWT
Price-Earnings Ratio = Price per share ÷ Earnings per share
CWT Price-Earnings Ratio = $41.75 ÷ $1.207 = 34.6x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CWT, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 34.6, CWT’s P/E is higher than its industry peers (30.2). This implies that investors are overvaluing each dollar of CWT’s earnings. This multiple is a median of profitable companies of 25 Water Utilities companies in US including SIIC Environment Holdings, Companhia de Saneamento Básico do Estado de São Paulo – SABESP and China Everbright Water. You could think of it like this: the market is pricing CWT as if it is a stronger company than the average of its industry group.
Assumptions to be aware of
However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to CWT. If not, the difference in P/E might be a result of other factors. For example, if California Water Service Group is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to CWT may not be fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in CWT. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for CWT’s future growth? Take a look at our free research report of analyst consensus for CWT’s outlook.
- Past Track Record: Has CWT been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of CWT’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.