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Should You Be Tempted To Sell Energy Recovery, Inc. (NASDAQ:ERII) Because Of Its P/E Ratio?

Simply Wall St

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Energy Recovery, Inc.'s (NASDAQ:ERII) P/E ratio and reflect on what it tells us about the company's share price. Energy Recovery has a price to earnings ratio of 23.95, based on the last twelve months. That corresponds to an earnings yield of approximately 4.2%.

See our latest analysis for Energy Recovery

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 Energy Recovery:

P/E of 23.95 = $11.34 ÷ $0.47 (Based on the year 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Does Energy Recovery's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Energy Recovery has a higher P/E than the average (20.8) P/E for companies in the machinery industry.

NasdaqGS:ERII Price Estimation Relative to Market, July 31st 2019

Energy Recovery's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Energy Recovery increased earnings per share by a whopping 48% last year.

Remember: P/E Ratios Don't Consider The Balance Sheet

Don't forget that the P/E ratio considers market capitalization. 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.

How Does Energy Recovery's Debt Impact Its P/E Ratio?

With net cash of US$89m, Energy Recovery has a very strong balance sheet, which may be important for its business. Having said that, at 14% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Energy Recovery's P/E Ratio

Energy Recovery has a P/E of 23.9. That's higher than the average in its market, which is 18. 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. 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 Energy Recovery. 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 editorial-team@simplywallst.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.