Look, there's a lot to like about American Water Works (NYSE:AWK). It's the largest publicly traded water utility -- there aren't many to choose from -- and the only one valued in excess of $10 billion. Each year it's investing billions of dollars to modernize its infrastructure -- and up to $40 billion in the next 25 years -- to race ahead of peers and make its revenue base more profitable. It boasts the most favorable valuation metrics among its peer groups and the most favorable growth expectations.
Then again, "most favorable" is a relative term. While I'm generally bullish on the long term prospects of American Water Works, the bear case is pretty straightforward: water utilities trade at expensive valuations and are inherently slow-growth businesses.
The bear case, explained
Several easy-to-understand valuation metrics explain why investors may want to think twice about their high hopes for American Water Works (or water stocks in general). Financial ratios such as price-to-earnings, price-to-sales, or PEG serve as a quick gauge for determining whether or not a stock represents value with respect to earnings, sales, and expected growth.
Unfortunately, none of these indicators paints American Water Works favorably. The company is more expensive than the S&P 500 on both an earnings and a sales basis.
Although not shown in the chart above, the stock's trailing twelve-month price to sales ratio of 4.3 is more than double that of the S&P 500, which trades at a comparably low 2.1x sales.
In addition to being relatively expensive compared to the broader market, Wall Street isn't expecting the stock to grow very quickly in the next five years. This is demonstrated by the PEG ratio: a value under 1 indicates the stock is undervalued with respect to its growth rate, and values greater than 1 indicate investors are paying a high price for the growth being achieved. American Water Works currently sports a PEG ratio of 3.4 -- well above 1.4 for the S&P 500.
The silver lining here may be that American Water Works is among the best water stocks to own. It trades at more attractive valuations based on both sales and future earnings than its next closest peer, Aqua America. It also owns a lower PEG ratio than its competitor, meaning Wall Street expects the larger water stock to beat out Aqua America in terms of growth rates in the next five years.
But, as mentioned above, it's all relative. Investors chasing growth and value can certainly find more and better elsewhere.
What does it mean for investors?
The bear case is simple: there's no denying that water stocks are more expensive and slower-growing than other stocks as a whole. That comes with the territory for water utilities. So although American Water Works benefits from operating in a highly regulated industry by enjoying government-backed infrastructure improvements, the structure of the industry also provides limitations to the rates of growth that are possible to achieve.