To the annoyance of some shareholders, Healthcare Services Group (NASDAQ:HCSG) shares are down a considerable 39% in the last month. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 44% drop over twelve months.
All else being equal, a share price drop should make a stock more attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
How Does Healthcare Services Group's P/E Ratio Compare To Its Peers?
Healthcare Services Group has a P/E ratio of 20.50. As you can see below Healthcare Services Group has a P/E ratio that is fairly close for the average for the commercial services industry, which is 20.9.
Its P/E ratio suggests that Healthcare Services Group shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
How Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Healthcare Services Group's earnings per share fell by 23% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 23%. And it has shrunk its earnings per share by 6.5% per year over the last three years. This growth rate might warrant a low P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Healthcare Services Group's Balance Sheet
Since Healthcare Services Group holds net cash of US$108m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Healthcare Services Group's P/E Ratio
Healthcare Services Group trades on a P/E ratio of 20.5, which is above its market average of 12.7. The recent drop in earnings per share would make some investors cautious, but the healthy balance sheet means the company retains the potential for future growth. If this growth fails to materialise, the current high P/E could prove to be temporary, as the share price falls. Given Healthcare Services Group's P/E ratio has declined from 33.8 to 20.5 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Healthcare Services Group. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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