When close to half the companies in the United States have price-to-earnings ratios (or "P/E's") below 17x, you may consider Watsco, Inc. (NYSE:WSO) as a stock to avoid entirely with its 36.3x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/E.
There hasn't been much to differentiate Watsco's and the market's retreating earnings lately. It might be that many expect the company's earnings to strengthen positively despite the tough market conditions, which has kept the P/E from falling. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.
Keen to find out how analysts think Watsco's future stacks up against the industry? In that case, our free report is a great place to start.
What Are Growth Metrics Telling Us About The High P/E?
There's an inherent assumption that a company should far outperform the market for P/E ratios like Watsco's to be considered reasonable.
Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 1.8%. This has soured the latest three-year period, which nevertheless managed to deliver a decent 23% overall rise in EPS. So we can start by confirming that the company has generally done a good job of growing earnings over that time, even though it had some hiccups along the way.
Looking ahead now, EPS is anticipated to slump, contracting by 1.9% per annum during the coming three years according to the eight analysts following the company. With the market predicted to deliver 10% growth per annum, that's a disappointing outcome.
In light of this, it's alarming that Watsco's P/E sits above the majority of other companies. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. Only the boldest would assume these prices are sustainable as these declining earnings are likely to weigh heavily on the share price eventually.
What We Can Learn From Watsco's P/E?
Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.
We've established that Watsco currently trades on a much higher than expected P/E for a company whose earnings are forecast to decline. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings are highly unlikely to support such positive sentiment for long. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.
Before you take the next step, you should know about the 3 warning signs for Watsco (1 is potentially serious!) that we have uncovered.
If these risks are making you reconsider your opinion on Watsco, explore our interactive list of high quality stocks to get an idea of what else is out there.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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