This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Consolidated Water Co Ltd (NASDAQ:CWCO) is currently trading at a trailing P/E of 27.4, which is close to the industry average of 27.8. While this makes CWCO appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for CWCO
Price-Earnings Ratio = Price per share ÷ Earnings per share
CWCO Price-Earnings Ratio = $13.12 ÷ $0.479 = 27.4x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to CWCO, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Consolidated Water Co Ltd (NASDAQ:CWCO) is currently trading at a trailing P/E of 27.4, which is close to the industry average of 27.8. This multiple is a median of profitable companies of 12 Water Utilities companies in US including New England Service Company, Torrington Water and Artesian Resources. You can think of it like this: the market is suggesting that CWCO has similar prospects to its peers in the same industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to CWCO, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with CWCO, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing CWCO to are fairly valued by the market. If this does not hold true, CWCO’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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 add more of CWCO to your portfolio. 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 CWCO’s future growth? Take a look at our free research report of analyst consensus for CWCO’s outlook.
- Past Track Record: Has CWCO 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 CWCO’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 firstname.lastname@example.org.