Last year was an excellent one for American Water Works (AWK 0.51%). Shares rose 26.4%, which crushed the market's return since the S&P 500 only gained 19.4%. Several factors drove that strong performance, including solid earnings growth of about 7% and a 10% increase in the company's dividend.
As good as last year was, the water utility expects 2018 to be even better from a financial results standpoint. However, that doesn't necessarily mean it will be another good one for investors since the stock's value has been growing at a much faster clip than earnings have increased.
A glimpse at what lies ahead
In mid-January, American Water Works released its 2018 guidance, expecting earnings to be between $3.22 to $3.32 per share. With the company still anticipating 2017's profits to be between $3.05 to $3.11 per share, the forecast implies a 6.2% increase at the midpoint of both ranges. That's a slightly slower pace than last year, when the company was on track to increase earnings 6% to 8% versus 2015.
That said, 2018 is just the first year of the company's ambitious five-year plan, which should see it increase earnings at a 7% to 10% compound annual growth rate through 2022, with dividend growth expected at the high end of that range. Driving this growth will be the $8 billion to $8.6 billion of capital projects the company has under way to expand its water business. In addition to that visible growth, the company has an excellent track record of making acquisitions, which could drive additional earnings growth in the coming years. In other words, while 2018 is on track to be its best yet, even better days lie ahead.
Is the upside drying up?
Investors have clearly bought into the company's growth potential. Not only were shares up by more than a quarter last year, but the stock has gained 116% in the past five years. Earnings, however, haven't grown quite that fast, up about 40% over that time frame. Because of that, shares now trade at more than 28 times earnings after only fetching about 18 times earnings five years ago.
American Water Works isn't the only water stock that has experienced a big uptick in valuation during the past five years. Both California Water Service Group (CWT 1.12%) and Aqua America (WTRG 1.78%) have seen their price-to-earnings (P/E) multiple expand at a brisk pace. California Water Service's P/E ratio went from less than 17 times to more than 28 times, a 72% increase, even though earnings have only risen about 28%. Meanwhile, Aqua America's P/E ratio has expanded from around 20 times to more than 27 times, or about 41%, even though earnings have only increased about 14% over that time frame. Those are rich multiples considering that these companies are on pace to grow earnings at mid-single to low double-digit rates in the coming years. Because of that, their stocks might eventually take a breather so earnings can catch up to the valuation. In fact, all three were down sharply in January, with California Water Service leading the sell-off by declining 10%, followed by a 9% dip from American Water Works and a 7.5% drop from Aqua America.
Great company, but not a good stock to buy
While American Water Works is on pace to deliver its most profitable year ever, that might not be enough for investors to enjoy a repeat performance of 2017's market-crushing return since shares still fetch quite a premium price even after selling off in January. Accordingly, investors might want to consider a cheaper, up-and-coming water stock instead, with one top option standing out due to its lower valuation, higher yield, and equally impressive growth prospects.