Should You Be Tempted To Buy HMS Holdings Corp (NASDAQ:HMSY) At Its Current PE Ratio?

This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between HMS Holdings Corp (NASDAQ:HMSY)’s fundamentals and stock market performance.

HMS Holdings Corp (NASDAQ:HMSY) is trading with a trailing P/E of 41.6x, which is lower than the industry average of 43.7x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for HMS Holdings

What you need to know about the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.

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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as HMSY, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.

Since HMSY's P/E of 41.6x is lower than its industry peers (43.7x), it means that investors are paying less than they should for each dollar of HMSY's earnings. Therefore, according to this analysis, HMSY is an under-priced stock.

Assumptions to be aware of

Before you jump to the conclusion that HMSY represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to HMSY. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with HMSY, then HMSY’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with HMSY, HMSY’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing HMSY to are fairly valued by the market. If this assumption is violated, HMSY's P/E may be lower than its peers because its peers are actually overvalued by investors.

What this means for you:

Since you may have already conducted your due diligence on HMSY, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined 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:

1. Future Outlook: What are well-informed industry analysts predicting for HMSY’s future growth? Take a look at our free research report of analyst consensus for HMSY’s outlook.
2. Past Track Record: Has HMSY 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 HMSY's historicals for more clarity.
3. 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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.