The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

Ramsay Health Care Limited (ASX:RHC) is currently trading at a trailing P/E of 29.4, which is higher than the industry average of 19.2. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.

Check out our latest analysis for Ramsay Health Care

What you need to know about the P/E ratio

P/E is a popular ratio used for relative valuation. 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.

P/E Calculation for RHC

Price-Earnings Ratio = Price per share ÷ Earnings per share

RHC Price-Earnings Ratio = A$54.93 ÷ A$1.867 = 29.4x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to RHC, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. RHC’s P/E of 29.4 is higher than its industry peers (19.2), which implies that each dollar of RHC’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 22 Healthcare companies in AU including Traditional Therapy Clinics, Summerset Group Holdings and Oceania Healthcare. You could think of it like this: the market is pricing RHC as if it is a stronger company than the average of its industry group.

Assumptions to be aware of

However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to RHC. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Ramsay Health Care Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with RHC are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.

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 RHC. 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 RHC’s future growth? Take a look at our free research report of analyst consensus for RHC’s outlook.

2. Past Track Record: Has RHC 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 RHC’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.

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 editorial-team@simplywallst.com.