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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Select Medical Holdings Corporation’s (NYSE:SEM) P/E ratio could help you assess the value on offer. Select Medical Holdings has a price to earnings ratio of 9.6, based on the last twelve months. That is equivalent to an earnings yield of about 10%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Select Medical Holdings:
P/E of 9.6 = $15.29 ÷ $1.59 (Based on the year to September 2018.)
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.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the ‘E’ will be higher. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Select Medical Holdings increased earnings per share by a whopping 119% last year. And earnings per share have improved by 9.0% annually, over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
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. If you look at the image below, you can see Select Medical Holdings has a lower P/E than the average (21.4) in the healthcare industry classification.
This suggests that market participants think Select Medical Holdings will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
The ‘Price’ in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
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.
Select Medical Holdings’s Balance Sheet
Select Medical Holdings’s net debt is considerable, at 154% of its market cap. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.
The Bottom Line On Select Medical Holdings’s P/E Ratio
Select Medical Holdings’s P/E is 9.6 which is below average (16.8) in the US market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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.
But note: Select Medical Holdings may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com.