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Why HealthEquity, Inc.'s (NASDAQ:HQY) High P/E Ratio Isn't Necessarily A Bad Thing

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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use HealthEquity, Inc.'s (NASDAQ:HQY) P/E ratio to inform your assessment of the investment opportunity. What is HealthEquity's P/E ratio? Well, based on the last twelve months it is 41.81. In other words, at today's prices, investors are paying \$41.81 for every \$1 in prior year profit.

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price Ã· Earnings per Share (EPS)

Or for HealthEquity:

P/E of 41.81 = \$62.69 Ã· \$1.5 (Based on the trailing twelve months to April 2019.)

Is A High P/E Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

How Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.

HealthEquity's earnings made like a rocket, taking off 63% last year. Even better, EPS is up 63% per year over three years. So you might say it really deserves to have an above-average P/E ratio.

How Does HealthEquity's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, HealthEquity has a higher P/E than the average company (20.8) in the healthcare industry.

HealthEquity's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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 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 HealthEquity's Balance Sheet Tell Us?

The extra options and safety that comes with HealthEquity's US\$329m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Verdict On HealthEquity's P/E Ratio

HealthEquity has a P/E of 41.8. That's higher than the average in the US market, which is 18.2. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect HealthEquity to have a high P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than HealthEquity. 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.