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A Rising Share Price Has Us Looking Closely At Azure Healthcare Limited's (ASX:AZV) P/E Ratio

Simply Wall St

Azure Healthcare (ASX:AZV) shares have had a really impressive month, gaining 46%, after some slippage. But shareholders may not all be feeling jubilant, since the share price is still down 18% in the last year.

Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. 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). The implication here is that deep value investors might steer clear when expectations of a company are too high. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.

Check out our latest analysis for Azure Healthcare

Does Azure Healthcare Have A Relatively High Or Low P/E For Its Industry?

Azure Healthcare's P/E is 27.77. You can see in the image below that the average P/E (29.5) for companies in the medical equipment industry is roughly the same as Azure Healthcare's P/E.

ASX:AZV Price Estimation Relative to Market, October 27th 2019

Azure Healthcare's P/E tells us that market participants think its prospects are roughly in line with its industry. So if Azure Healthcare actually outperforms its peers going forward, that should be a positive for the share price. Checking factors such as director buying and selling. could help you form your own view on if that will happen.

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. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Azure Healthcare saw earnings per share decrease by 47% last year. And EPS is down 33% a year, over the last 5 years. This might lead to muted expectations.

Remember: P/E Ratios Don't Consider The Balance Sheet

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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 Azure Healthcare's Balance Sheet Tell Us?

The extra options and safety that comes with Azure Healthcare's AU$1.7m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Bottom Line On Azure Healthcare's P/E Ratio

Azure Healthcare trades on a P/E ratio of 27.8, which is above its market average of 18.5. The recent drop in earnings per share might keep value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will! What is very clear is that the market has become significantly more optimistic about Azure Healthcare over the last month, with the P/E ratio rising from 19.0 back then to 27.8 today. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.

Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. Although we don't have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

But note: Azure Healthcare 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).

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.