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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). 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. American Water Works Company has a P/E ratio of 32.92, based on the last twelve months. That corresponds to an earnings yield of approximately 3.0%.
How Do You Calculate American Water Works Company's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for American Water Works Company:
P/E of 32.92 = $103.71 ÷ $3.15 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
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 4.6%. With that performance, I would expect it to have an above average P/E ratio.
How Does American Water Works Company's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (33.3) for companies in the water utilities industry is roughly the same as American Water Works Company's P/E.
That indicates that the market expects American Water Works Company will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. I inform my view byby checking management tenure and remuneration, among other things.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
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.
American Water Works Company's Balance Sheet
Net debt totals 45% of American Water Works Company's market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Verdict On American Water Works Company's P/E Ratio
American Water Works Company trades on a P/E ratio of 32.9, which is above the US market average of 17.7. While the company does use modest debt, its recent earnings growth is impressive. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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.