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Is Watsco, Inc.'s (NYSE:WSO) High P/E Ratio A Problem For Investors?

Simply Wall St

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Watsco, Inc.'s (NYSE:WSO) P/E ratio and reflect on what it tells us about the company's share price. Watsco has a P/E ratio of 23.28, based on the last twelve months. That corresponds to an earnings yield of approximately 4.3%.

View our latest analysis for Watsco

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Watsco:

P/E of 23.28 = $151.33 ÷ $6.5 (Based on the trailing twelve months to December 2018.)

Is A High P/E 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 Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. 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.

It's great to see that Watsco grew EPS by 12% in the last year. And its annual EPS growth rate over 5 years is 12%. This could arguably justify a relatively high P/E ratio.

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

The P/E ratio essentially measures market expectations of a company. As you can see below, Watsco has a higher P/E than the average company (15.8) in the trade distributors industry.

NYSE:WSO Price Estimation Relative to Market, April 21st 2019

That means that the market expects Watsco will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and selling.

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. That means it doesn't take debt or cash into account. 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).

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 Watsco's Balance Sheet Tell Us?

Watsco has net debt worth just 0.9% 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 Verdict On Watsco's P/E Ratio

Watsco has a P/E of 23.3. That's higher than the average in the US market, which is 18.2. While the company does use modest debt, its recent earnings growth is very good. Therefore, it's not particularly surprising that it has a above average P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

But note: Watsco 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 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.