This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll show how you can use Chemed Corporation’s (NYSE:CHE) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Chemed’s P/E ratio is 23.52. That means that at current prices, buyers pay $23.52 for every $1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Chemed:
P/E of 23.52 = $301.4 ÷ $12.81 (Based on the year to September 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Chemed increased earnings per share by a whopping 172% last year. And its annual EPS growth rate over 5 years is 14%. So we’d generally expect it to have a relatively high P/E ratio.
How Does Chemed’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Chemed has a higher P/E than the average (20.3) P/E for companies in the healthcare industry.
Chemed’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
Chemed’s Balance Sheet
Chemed’s net debt is 1.3% of its market cap. So it doesn’t have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Verdict On Chemed’s P/E Ratio
Chemed’s P/E is 23.5 which is above average (17.2) in the US market. Its debt levels do not imperil its balance sheet and it has already proven it can grow. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
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 they key to an excellent investment decision.
You might be able to find a better buy than Chemed. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.