Pro Medicus Limited (ASX: PME) shares have been on an incredible run over the past year.
Shares in the healthcare imaging business were swapping hands at $164.22 at the close of trading yesterday, up more than 70% this year to date.
The company also touched new all-time highs earlier this week. Naturally, many investors must be wondering if now is the right time to buy.
But before investing, one crucial factor to consider is the stock's lofty price-to-earnings (P/E) ratio.
Valuations matter – a lot. So this is an important talking point. Let's dive in.
Pro Medicus' valuation: A risk to keep in mind
Pro Medicus shares currently trade at an eye-watering P/E ratio of 207.6 times, which has ballooned from 122 times in June 2023.
To put that into perspective, a P/E ratio this high means investors are paying $207 for every $1 of earnings the company generates. Bargain anyone?
While growth stocks often carry premium valuations, Pro Medicus' current multiple raises the risk of a potential contraction. Let me explain.
Pro Medicus shares have risen 129.5% in the last 12 months. However, net profit increased just 36% year over year in FY24, to 79 cents per share.
The rest of the stock price change is due to the P/E expanding — up from 144 times in September of last year.
If investors were still paying the 144 times P/E multiple, Pro Medicus shares would be $113 apiece (144 x $0.79 = $113).
As such, the risk for investors is that the multiple contracts and reduces the investment return, regardless of how well the company's earnings grow.
And we've seen this exact thing happen before, in the period between June 2021 and June 2022.
Back in June 2021, Pro Medicus shares sold at a P/E of about 220 times. If you had invested then, you paid $220 for a dollar of earnings. In the following 12 months, Pro Medicus' profits grew from $0.43 per share to $0.58 per share, a 35% growth.
This was a great business result that you'd think would translate into a great investment result. But that wasn't the case.
Instead, for varying reasons, the P/E multiple contracted to 107 times. Investors were paying less for a dollar of earnings.
As a result, the stock price fell from $56.67 at the end of June 2021 to $42.44 in June 2022.
So, despite profits being up 35% year over year, Pro Medicus shares decreased by 25%. This is precisely why valuations matter.
Going forward, the risk is that the P/E multiple will contract sharply again, reducing the investor's return –despite whatever business growth.
What do analysts say?
Goldman Sachs remains bullish, recently reaffirming its buy rating on Pro Medicus shares.
The broker highlights the company's strong contract pipeline and expects it to perform well into FY25, thanks to new contract wins and contributions from large, high-profile deals.
However, other analysts are more cautious.
According to CommSec, the consensus view is to hold Pro Medicus shares, with three buy ratings, nine hold ratings, and two sell recommendations.
Foolish takeaway
Pro Medicus shares have been on a stellar run, but the stock's sky-high P/E ratio is a key factor that investors need to consider before buying.
The stock has lifted by more than 129% in the past 12 months.
