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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use Consolidated Water Co. Ltd.'s (NASDAQ:CWCO) P/E ratio to inform your assessment of the investment opportunity. Consolidated Water has a price to earnings ratio of 19.62, based on the last twelve months. In other words, at today's prices, investors are paying $19.62 for every $1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Consolidated Water:
P/E of 19.62 = $14.36 ÷ $0.73 (Based on the trailing twelve months to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Consolidated Water's 158% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Having said that, if we look back three years, EPS growth has averaged a comparatively less impressive 12%.
How Does Consolidated Water's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Consolidated Water has a lower P/E than the average (35.9) P/E for companies in the water utilities industry.
Consolidated Water's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Is Debt Impacting Consolidated Water's P/E?
With net cash of US$38m, Consolidated Water has a very strong balance sheet, which may be important for its business. Having said that, at 18% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Consolidated Water's P/E Ratio
Consolidated Water has a P/E of 19.6. That's higher than the average in the US market, which is 18.2. The excess cash it carries is the gravy on top its fast EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings).
Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Consolidated Water 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.