Should You Be Tempted To Sell Catasys Inc (NASDAQ:CATS) Because Of Its PE Ratio?

I am writing today to help inform people who are new to the stock market and want to better understand how you can grow your money by investing in Catasys Inc (NASDAQ:CATS).

Catasys Inc (NASDAQ:CATS) trades with a trailing P/E of 33.8x, which is higher than the industry average of 22.1x. While this makes CATS appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View out our latest analysis for Catasys

What you need to know about the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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.

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 CATS, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

At 33.8x, CATS’s P/E is higher than its industry peers (22.1x). This implies that investors are overvaluing each dollar of CATS’s earnings. As such, our analysis shows that CATS represents an over-priced stock.

A few caveats

Before you jump to the conclusion that CATS should be banished from your portfolio, 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 CATS. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with CATS, then CATS’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with CATS. In this case, CATS’s P/E would be higher since investors would also reward CATS’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CATS to are fairly valued by the market. If this does not hold, there is a possibility that CATS’s P/E is higher because firms in our peer group are being undervalued by the market.

What this means for you:

If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in CATS. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 CATS’s future growth? Take a look at our free research report of analyst consensus for CATS’s outlook.
2. Past Track Record: Has CATS 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 CATS'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.