Should You Be Tempted To Sell HealthStream, Inc. (NASDAQ:HSTM) Because Of Its P/E Ratio?

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to HealthStream, Inc.'s (NASDAQ:HSTM), to help you decide if the stock is worth further research. HealthStream has a P/E ratio of 68.80, based on the last twelve months. That corresponds to an earnings yield of approximately 1.5%.

See our latest analysis for HealthStream

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for HealthStream:

P/E of 68.80 = $28.86 ÷ $0.42 (Based on the year to September 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

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

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (64.1) for companies in the healthcare services industry is roughly the same as HealthStream's P/E.

Its P/E ratio suggests that HealthStream shareholders think that in the future it will perform about the same as other companies in its industry classification. So if HealthStream actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

HealthStream maintained roughly steady earnings over the last twelve months. But EPS is up 3.9% over the last 5 years.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

HealthStream's Balance Sheet

With net cash of US$173m, HealthStream has a very strong balance sheet, which may be important for its business. Having said that, at 19% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Bottom Line On HealthStream's P/E Ratio

HealthStream's P/E is 68.8 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. Falling earnings per share is probably keeping traditional value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. 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 HealthStream. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.

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. Thank you for reading.