Why I think Ramsay Health Care Limited shares could be a sell

So far in 2016 the share price of private hospital operator Ramsay Health Care Limited (ASX: RHC) has rallied close to 20% compared with a gain of just 2% in the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO).

While the stock currently looks on the expensive side (in my opinion) – trading near $80 – it’s worth considering whether the shares could continue to trend higher.

Fundamental analysis

Analysis of a company can be broadly segmented into two categories – qualitative and quantitative.

As the names suggest, the qualitative category considers factors such as the quality of a business model, management’s experience and industry position.

Meanwhile, the quantitative category hones in on factors such as growth rates in revenue and other metrics such as margins and leverage.

Before we turn our attention to qualitative and quantitative factors, let’s first look at how the market is pricing Ramsay…

Based on the recently reported full year results for financial year (FY) 2016 the stock is trading on a price-to-earnings (PE) multiple of 36 times.

Looking out over the next two full year reporting periods, according to analyst consensus data provided by Reuters, earnings per share (EPS) are set to rise to 259 cents per share (cps) in FY 2017 and then to 289 cps in FY 2018. These forecasts imply respective PE multiples of 32 times and 29 times

For context, it can often be informative to compare the pricing of a stock against a peer group or market index.

Healthscope Ltd (ASX: HSO) is the closest listed peer to Ramsay. Using Reuters data for FY 2017 and FY 2018, suggests Healthscope is trading on a forecast PE of roughly 25 times and 22.5 times respectively.

Some investors will consider Ramsay a superior business to Healthscope and hence a premium to be justified. A premium could well be warranted, however, investors also need to consider the magnitude!

Turning now to qualitative factors…

Operating across six countries and 223 hospitals, Ramsay has numerous growth levers at its disposal.

In FY 2016 growth came from a variety of channels. These channels included organic growth thanks to volume expansion and positive demographics, the acquisition of hospitals in France, and over $300 million in brownfield capacity expansion.

Management has a solid track record of identifying and successfully executing growth initiatives and this was certainly the case again in FY 2016.

Quantitative factors to consider…

FY 2016 saw Ramsay’s revenue increase 18% to $8.7 billion.

Earnings before interest and tax (EBIT) increased 11.6% to $897 million. The Australia/Asia region achieved double digit earnings growth, the UK achieved earnings growth of 9.5%, while France’s earnings growth was a muted 2.2%.

From a margin perspective, EBIT margins expanded across both the Australia/Asia and UK regions, with France’s performance declining as Ramsay worked through the integration of recent acquisitions.

Dividends totalling 119 cps fully franked, up 17.8%, were declared.

From a quantitative perspective Ramsay’s results in FY 2016 are hard to fault.

Foolish takeaway

While an accurate assessment of the future is what is required to successfully value Ramsay, the past can be instructive.

Core EPS have increased at a compound rate of 19.4% per annum (pa) over the past four years. Over the past 18 years, core EPS have grown at a compound rate of 16.8% pa!

That’s an outstanding achievement and it’s understandable that the market is enamoured with the stock.

This admiration could keep the momentum flowing for Ramsay’s share price and see it head to $100 in the not-too-distant future.

Based on an assessment of both qualitative and quantitative factors however, I’m not convinced that $100 a share would represent a fair valuation of the company in the near term.

With Ramsay’s management providing guidance for growth in core EPS of between 10% and 12% in FY 2017 the current multiple looks hard to justify.

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Motley Fool contributor Tim McArthur has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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