Despite Its High P/E Ratio, Is Sonic Healthcare Limited (ASX:SHL) Still Undervalued?

Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

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 Sonic Healthcare Limited’s (ASX:SHL) P/E ratio could help you assess the value on offer. What is Sonic Healthcare’s P/E ratio? Well, based on the last twelve months it is 24.54. In other words, at today’s prices, investors are paying A$24.54 for every A$1 in prior year profit.

See our latest analysis for Sonic Healthcare

How Do I Calculate Sonic Healthcare’s Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Sonic Healthcare:

P/E of 24.54 = A$27.09 ÷ A$1.1 (Based on the trailing twelve months to December 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each A$1 of company earnings. 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. 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.

Sonic Healthcare’s earnings per share were pretty steady over the last year. But over the longer term (5 years) earnings per share have increased by 4.0%.

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

We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Sonic Healthcare has a higher P/E than the average company (16.9) in the healthcare industry.

ASX:SHL Price Estimation Relative to Market, June 19th 2019
ASX:SHL Price Estimation Relative to Market, June 19th 2019

Sonic Healthcare’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors 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

It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. 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.

How Does Sonic Healthcare’s Debt Impact Its P/E Ratio?

Sonic Healthcare has net debt worth 16% of its market capitalization. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.

The Verdict On Sonic Healthcare’s P/E Ratio

Sonic Healthcare trades on a P/E ratio of 24.5, which is above the AU market average of 16.1. With modest debt relative to its size, and modest earnings growth, the market is likely expecting sustained long-term growth, if not a near-term improvement.

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.

But note: Sonic 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.