Healthscope Limited (ASX:HSO) is trading with a trailing P/E of 20.6x, which is higher than the industry average of 18.9x. While this makes HSO 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 explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Healthscope
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for HSO
Price-Earnings Ratio = Price per share ÷ Earnings per share
HSO Price-Earnings Ratio = A$1.93 ÷ A$0.094 = 20.6x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to HSO, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. HSO’s P/E of 20.6x is higher than its industry peers (18.9x), which implies that each dollar of HSO’s earnings is being overvalued by investors. As such, our analysis shows that HSO represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your HSO shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to HSO, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with HSO, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing HSO to are fairly valued by the market. If this does not hold, there is a possibility that HSO’s P/E is lower because our peer group is overvalued by the market.
To help readers see pass 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.