This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
National HealthCare Corporation (NYSEMKT:NHC) is trading with a trailing P/E of 21.4, which is close to the industry average of 21.7. While NHC might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the P/E 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 NHC
Price-Earnings Ratio = Price per share ÷ Earnings per share
NHC Price-Earnings Ratio = $73.69 ÷ $3.451 = 21.4x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to NHC, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. National HealthCare Corporation (NYSEMKT:NHC) is trading with a trailing P/E of 21.4, which is close to the industry average of 21.7. This multiple is a median of profitable companies of 25 Healthcare companies in US including Agility Health, InterCare DX and Quantum Medical Transport. You can think of it like this: the market is suggesting that NHC has similar prospects to its peers in the same industry.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to NHC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with NHC, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing NHC to are fairly valued by the market. If this does not hold true, NHC’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of NHC to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for NHC’s future growth? Take a look at our free research report of analyst consensus for NHC’s outlook.
- Past Track Record: Has NHC been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of NHC’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
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 firstname.lastname@example.org.