HealthEquity Inc (NASDAQ:HQY) is currently trading at a trailing P/E of 65.7x, which is higher than the industry average of 22.8x. While this makes HQY appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for HealthEquity
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for HQY
Price-Earnings Ratio = Price per share ÷ Earnings per share
HQY Price-Earnings Ratio = $49.85 ÷ $0.759 = 65.7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as HQY, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since HQY’s P/E of 65.7x is higher than its industry peers (22.8x), it means that investors are paying more than they should for each dollar of HQY’s earnings. As such, our analysis shows that HQY represents an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your HQY shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to HQY. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with HQY, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing HQY to are fairly valued by the market. If this does not hold, there is a possibility that HQY’s P/E is lower because our peer group is overvalued by the market.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.