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 Healthcare Services Group, Inc.'s (NASDAQ:HCSG), to help you decide if the stock is worth further research. Healthcare Services Group has a P/E ratio of 19.09, based on the last twelve months. That means that at current prices, buyers pay $19.09 for every $1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Healthcare Services Group:
P/E of 19.09 = $21.87 ÷ $1.15 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does Healthcare Services Group Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Healthcare Services Group has a lower P/E than the average (21.4) P/E for companies in the commercial services industry.
Its relatively low P/E ratio indicates that Healthcare Services Group shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It's great to see that Healthcare Services Group grew EPS by 21% in the last year. And its annual EPS growth rate over 5 years is 11%. This could arguably justify a relatively high P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.
So What Does Healthcare Services Group's Balance Sheet Tell Us?
Since Healthcare Services Group holds net cash of US$66m, 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 has a P/E of 19.1. That's higher than the average in its market, which is 17. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 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 find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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 email@example.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.