Watsco, Inc.'s (NYSE:WSO) price-to-earnings (or "P/E") ratio of 36.5x might make it look like a strong sell right now compared to the market in the United States, where around half of the companies have P/E ratios below 16x and even P/E's below 9x are quite common. Although, it's not wise to just take the P/E at face value as there may be an explanation why it's so lofty.

Recent times haven't been advantageous for Watsco as its earnings have been falling quicker than most other companies. One possibility is that the P/E is high because investors think the company will turn things around completely and accelerate past most others in the market. If not, then existing shareholders may be very nervous about the viability of the share price.

What Are Growth Metrics Telling Us About The High P/E?

There's an inherent assumption that a company should far outperform the market for P/E ratios like Watsco's to be considered reasonable.

If we review the last year of earnings, dishearteningly the company's profits fell to the tune of 15%. Even so, admirably EPS has lifted 65% in aggregate from three years ago, notwithstanding the last 12 months. So we can start by confirming that the company has generally done a very good job of growing earnings over that time, even though it had some hiccups along the way.

Looking ahead now, EPS is anticipated to climb by 13% per annum during the coming three years according to the twelve analysts following the company. Meanwhile, the rest of the market is forecast to only expand by 10.0% per year, which is noticeably less attractive.

With this information, we can see why Watsco is trading at such a high P/E compared to the market. Apparently shareholders aren't keen to offload something that is potentially eyeing a more prosperous future.

The Final Word

We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.

As we suspected, our examination of Watsco's analyst forecasts revealed that its superior earnings outlook is contributing to its high P/E. At this stage investors feel the potential for a deterioration in earnings isn't great enough to justify a lower P/E ratio. It's hard to see the share price falling strongly in the near future under these circumstances.

It is also worth noting that we have found 2 warning signs for Watsco that you need to take into consideration.

You might be able to find a better investment than Watsco. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a low P/E (but have proven they can grow earnings).

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