Here's How P/E Ratios Can Help Us Understand Universal Health Services, Inc. (NYSE:UHS)

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Universal Health Services, Inc.'s (NYSE:UHS) P/E ratio to inform your assessment of the investment opportunity. Universal Health Services has a price to earnings ratio of 17.84, based on the last twelve months. That is equivalent to an earnings yield of about 5.6%.

Check out our latest analysis for Universal Health Services

How Do I Calculate Universal Health Services's Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Universal Health Services:

P/E of 17.84 = USD143.94 ÷ USD8.07 (Based on the year to September 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price'.

How Does Universal Health Services's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (23.2) for companies in the healthcare industry is higher than Universal Health Services's P/E.

NYSE:UHS Price Estimation Relative to Market, January 17th 2020

This suggests that market participants think Universal Health Services will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Universal Health Services saw earnings per share decrease by 9.9% last year. But over the longer term (5 years) earnings per share have increased by 9.9%.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

How Does Universal Health Services's Debt Impact Its P/E Ratio?

Net debt is 31% of Universal Health Services's market cap. You'd want to be aware of this fact, but it doesn't bother us.

The Verdict On Universal Health Services's P/E Ratio

Universal Health Services has a P/E of 17.8. That's around the same as the average in the US market, which is 19.1. With modest debt, and a lack of recent growth, it would seem the market is expecting improvement in earnings.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

You might be able to find a better buy than Universal Health Services. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.