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Here's How P/E Ratios Can Help Us Understand Select Medical Holdings Corporation (NYSE:SEM)

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to Select Medical Holdings Corporation's (NYSE:SEM), to help you decide if the stock is worth further research. Select Medical Holdings has a P/E ratio of 15.55, based on the last twelve months. That is equivalent to an earnings yield of about 6.4%.

View our latest analysis for Select Medical Holdings

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Select Medical Holdings:

P/E of 15.55 = $16.73 ÷ $1.08 (Based on the year to March 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Does Select Medical Holdings's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (21.6) for companies in the healthcare industry is higher than Select Medical Holdings's P/E.

NYSE:SEM Price Estimation Relative to Market, July 29th 2019

This suggests that market participants think Select Medical Holdings will underperform other companies in its industry. Since the market seems unimpressed with Select Medical Holdings, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

When earnings fall, the 'E' decreases, over time. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

Select Medical Holdings saw earnings per share decrease by 26% last year. But it has grown its earnings per share by 5.8% per year over the last five years. And it has shrunk its earnings per share by 2.1% 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

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

So What Does Select Medical Holdings's Balance Sheet Tell Us?

Select Medical Holdings has net debt worth a very significant 141% of its market capitalization. This level of debt justifies a relatively low P/E, so remain cognizant of the debt, if you're comparing it to other stocks.

The Bottom Line On Select Medical Holdings's P/E Ratio

Select Medical Holdings trades on a P/E ratio of 15.5, which is below the US market average of 18. Given meaningful debt, and a lack of recent growth, the market looks to be extrapolating this recent performance; reflecting low expectations for the future.

When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course you might be able to find a better stock than Select Medical Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Thank you for reading.