Henry Schein, Inc. (NASDAQ: HSIC) trades at a P/E multiple of 25.7x, which is lower than the Healthcare sector median of 31.7x. While this makes HSIC appear like a stock to add to your portfolio, you might change your mind after gaining a better understanding of the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.

Understanding Valuation Multiples and the P/E Ratio

A Multiples Valuation, also known as a Comparable Companies Analysis, determines the value of a subject company by benchmarking the subject’s financial performance against similar public companies (Peer Group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.

A P/E Multiple is a valuation ratio that indicates the multiple of earnings investors are willing to pay for one share of a company:

P/E Multiple = Stock Price ÷ Earnings Per Share

The P/E ratio is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different. I compare Henry Schein’s P/E multiple to those of Cardinal Health, Inc. (NYSE: CAH), AmerisourceBergen Corporation (Holding Co) (NYSE: ABC), McKesson Corporation (NYSE: MCK) and Centene Corporation (NYSE: CNC) in the chart below.

^{source: finbox.io Benchmarks: P/E Multiples}

Since Henry Schein’s P/E of 25.7x is higher than the median of its peers (17.0x), it means that investors are paying more than they should for each dollar of HSIC’s earnings. As such, our analysis shows that HSIC represents an overvalued stock. In fact, finbox.io’s P/E Multiple Model calculates a fair value of $58.16 per share which implies -14.5% downside.

Note that the selected multiple of 22.0x in the analysis above was determined by averaging Henry Schein’s current P/E multiple with its peer group and sector.

Understanding the P/E Ratio’s Limitations

Before jumping to the conclusion that Henry Schein should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.

(1) the selected peer group actually contains companies that truly are similar to Henry Schein, and

(2) the selected peer group stocks are being fairly valued by the market.

If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare Henry Schein with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.