Healthcare Services Group Inc (NASDAQ:HCSG) is trading with a trailing P/E of 47.5x, which is higher than the industry average of 25.1x. While this makes HCSG 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. Check out our latest analysis for Healthcare Services Group

What you need to know about the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 HCSG

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

HCSG Price-Earnings Ratio = 54.94 ÷ 1.157 = 47.5x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to HCSG, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since HCSG's P/E of 47.5x is higher than its industry peers (25.1x), it means that investors are paying more than they should for each dollar of HCSG's earnings. Therefore, according to this analysis, HCSG is an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your HCSG shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to HCSG. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with HCSG, 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 HCSG to are fairly valued by the market. If this is violated, HCSG's P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on HCSG, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.

Are you a potential investor? If you are considering investing in HCSG, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Healthcare Services Group for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.