The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Middlesex Water Company's (NASDAQ:MSEX) P/E ratio could help you assess the value on offer. What is Middlesex Water's P/E ratio? Well, based on the last twelve months it is 31.11. That corresponds to an earnings yield of approximately 3.2%.
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 31.11 = $62.940 ÷ $2.023 (Based on the year to December 2019.)
(Note: the above calculation results may not be precise due to rounding.)
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. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price'.
How Does Middlesex 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 Middlesex Water has a lower P/E than the average (38.5) P/E for companies in the water utilities industry.
This suggests that market participants think Middlesex Water will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. 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.
Middlesex Water saw earnings per share improve by 2.6% last year. And earnings per share have improved by 12% annually, over the last five years.
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. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
Is Debt Impacting Middlesex Water's P/E?
Net debt totals 23% of Middlesex Water's market cap. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.
The Verdict On Middlesex Water's P/E Ratio
Middlesex Water's P/E is 31.1 which is above average (14.0) in its market. With modest debt relative to its size, and modest earnings growth, the market is likely expecting sustained long-term growth, if not a near-term improvement.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. 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 Middlesex Water. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.
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