To the annoyance of some shareholders, Select Medical Holdings (NYSE:SEM) shares are down a considerable 40% in the last month. Looking back further, the stock is up 4.9% in the last year.
All else being equal, a share price drop should make a stock more attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). The implication here is that long term investors have an opportunity when expectations of a company are too low. Perhaps the simplest way to get a read on investors’ expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
Does Select Medical Holdings Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 13.93 that sentiment around Select Medical Holdings isn’t particularly high. The image below shows that Select Medical Holdings has a lower P/E than the average (16.9) P/E for companies in the healthcare industry.
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. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
Select Medical Holdings’s earnings per share grew by 7.6% in the last twelve months. And it has bolstered its earnings per share by 3.9% per year over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. So it won’t reflect the advantage of cash, or disadvantage of debt. 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).
Select Medical Holdings’s Balance Sheet
Net debt totals a substantial 150% of Select Medical Holdings’s market cap. 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 Verdict On Select Medical Holdings’s P/E Ratio
Select Medical Holdings trades on a P/E ratio of 13.9, which is above its market average of 12.7. With significant debt and fairly modest EPS growth last year, shareholders are betting on sustained improvement. What can be absolutely certain is that the market has become significantly less optimistic about Select Medical Holdings over the last month, with the P/E ratio falling from 23.2 back then to 13.9 today. For those who don’t like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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