Aqua America Inc (NYSE: WTR) trades at a P/E multiple of 25.3x, which is higher than the Utilities sector median of 20.7x. While this makes WTR appear like a stock to avoid or sell if you own it, you might change your mind after gaining a better understanding of the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
How To Utilize PE Multiples
A Multiples Valuation, also known as a Comparable Companies Analysis, determines the value of a subject company by benchmarking the subject's financial performance against similar public companies (Peer Group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
A P/E Multiple is a valuation ratio that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Multiple = Stock Price ÷ Earnings Per Share
The P/E ratio is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different. I compare Aqua America's P/E multiple to those of California Water Service Group Holding (NYSE: CWT), American Water Works (NYSE: AWK), American States Water Company (NYSE: AWR) and Artesian Resources Corporation (NASDAQ: ARTNA) in the chart below.
Since Aqua America's P/E of 25.3x is lower than the median of its peers (27.4x), it means that investors are paying less than they should for each dollar of WTR's earnings. As such, our analysis shows that WTR represents an undervalued stock. In fact, finbox.io's P/E Multiple Model calculates a fair value of $37.90 per share which implies 13.5% upside.
Note that the selected multiple of 28.1x in the analysis above was determined by averaging Aqua America's current P/E multiple with its peer group.
Understanding the P/E Ratio's Limitations
Before jumping to the conclusion that Aqua America should be added to your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to Aqua America, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare Aqua America with higher growth companies, then its P/E multiple would naturally be lower than its peers since investors reward high growth stocks with a higher price.
source: P/E model
Now if the second assumption does not hold true, Aqua America's lower multiple may be because firms in our peer group are being overvalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current undervaluation could signal a potential buying opportunity to increase your position in WTR. However, keep in mind the limitations of the P/E ratio when making investment decisions. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on Aqua America by taking a look at the following:
Valuation Metrics: how much upside do shares of Aqua America have based on the Ben Graham Formula? Take a look at our Ben Graham Formula data explorer which also compares the company's upside to its peers.
Efficiency Metrics: is management becoming more or less efficient in creating value for the firm? Find out by analyzing the company's return on invested capital ratio here.
Forecast Metrics: what is Aqua America's projected EBITDA margin? Is the company expected to improve its profitability going forward? Analyze the company's projected EBITDA margin here.
Article by Brian Dentino, Finbox.io