This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Select Medical Holdings Corporation’s (NYSE:SEM) P/E ratio could help you assess the value on offer. Select Medical Holdings has a P/E ratio of 13.69, based on the last twelve months. That is equivalent to an earnings yield of about 7.3%.
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 Select Medical Holdings:
P/E of 13.69 = $14.02 ÷ $1.02 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings 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. Earnings growth means that in the future the ‘E’ will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Select Medical Holdings saw earnings per share decrease by 23% last year. But EPS is up 8.5% over the last 5 years.
How Does Select Medical Holdings’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Select Medical Holdings has a lower P/E than the average (21.4) in the healthcare industry classification.
Its relatively low P/E ratio indicates that Select Medical Holdings shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Select Medical Holdings, it’s quite possible it could surprise on the upside. You 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
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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).
How Does Select Medical Holdings’s Debt Impact Its P/E Ratio?
Select Medical Holdings has net debt worth a very significant 166% of its market capitalization. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.
The Bottom Line On Select Medical Holdings’s P/E Ratio
Select Medical Holdings’s P/E is 13.7 which is below average (17.7) in the US market. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage.
Investors have an opportunity when market expectations about a stock are wrong. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Select Medical Holdings 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).
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