This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Xylem Inc.'s (NYSE:XYL), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Xylem has a P/E ratio of 24.6. That corresponds to an earnings yield of approximately 4.1%.
How Do I Calculate Xylem's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Xylem:
P/E of 24.6 = $78.39 ÷ $3.19 (Based on the year to June 2019.)
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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does Xylem Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (19.7) for companies in the machinery industry is lower than Xylem's P/E.
Its relatively high P/E ratio indicates that Xylem shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
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. Then, a lower P/E should attract more buyers, pushing the share price up.
Xylem's 55% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The cherry on top is that the five year growth rate was an impressive 16% per year. So I'd be surprised if the P/E ratio was not above average.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
How Does Xylem's Debt Impact Its P/E Ratio?
Xylem's net debt is 15% 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 Bottom Line On Xylem's P/E Ratio
Xylem's P/E is 24.6 which is above average (17.5) in its market. Its debt levels do not imperil its balance sheet and its EPS growth is very healthy indeed. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Xylem may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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 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.