This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use Middlesex Water Company's (NASDAQ:MSEX) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, Middlesex Water has a P/E ratio of 32.15. That corresponds to an earnings yield of approximately 3.1%.
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 Middlesex Water:
P/E of 32.15 = $66.19 ÷ $2.06 (Based on the trailing twelve months to June 2019.)
Is A High P/E 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 Does Middlesex Water's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Middlesex Water has a lower P/E than the average (40.0) in the water utilities industry classification.
Its relatively low P/E ratio indicates that Middlesex Water shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Middlesex Water, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Notably, Middlesex Water grew EPS by a whopping 29% in the last year. And it has bolstered its earnings per share by 14% per year over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.
So What Does Middlesex Water's Balance Sheet Tell Us?
Net debt totals 21% of Middlesex Water's market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Bottom Line On Middlesex Water's P/E Ratio
Middlesex Water trades on a P/E ratio of 32.2, which is above its market average of 17.9. The company is not overly constrained by its modest debt levels, and its recent EPS growth very solid. So on this analysis it seems reasonable that its P/E ratio is above average.
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.
You might be able to find a better buy than Middlesex Water. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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 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.