Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Watts Water Technologies, Inc.'s (NYSE:WTS) P/E ratio and reflect on what it tells us about the company's share price. Watts Water Technologies has a P/E ratio of 24.67, based on the last twelve months. That corresponds to an earnings yield of approximately 4.1%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Watts Water Technologies:
P/E of 24.67 = $94.79 ÷ $3.84 (Based on the year to June 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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.
Does Watts Water Technologies Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. As you can see below, Watts Water Technologies has a higher P/E than the average company (20.7) in the machinery industry.
That means that the market expects Watts Water Technologies will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Notably, Watts Water Technologies grew EPS by a whopping 49% in the last year. And it has bolstered its earnings per share by 17% per year over the last five years. So we'd generally expect it to have a relatively high P/E ratio.
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. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
So What Does Watts Water Technologies's Balance Sheet Tell Us?
Watts Water Technologies has net debt worth just 5.5% of its market capitalization. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Bottom Line On Watts Water Technologies's P/E Ratio
Watts Water Technologies has a P/E of 24.7. That's higher than the average in its market, which is 17.9. Its debt levels do not imperil its balance sheet and its EPS growth is very healthy indeed. So on this analysis a high P/E ratio seems reasonable.
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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
Of course you might be able to find a better stock than Watts Water Technologies. So you may wish to see this free collection of other companies that have grown earnings strongly.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.