Cherry Hill Mortgage Investment Corporation (NYSE:CHMI) is trading with a trailing P/E of 3x, which is lower than the industry average of 8.4x. While this makes CHMI appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for CHMI
Breaking down the Price-Earnings 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for CHMI
Price per share = 17.74
Earnings per share = 5.91
∴ Price-Earnings Ratio = 17.74 ÷ 5.91 = 3x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as CHMI, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
CHMI’s P/E of 3x is lower than its industry peers (8.4x), which implies that each dollar of CHMI’s earnings is being undervalued by investors. As such, our analysis shows that CHMI represents an under-priced stock.
A few caveats
Before you jump to the conclusion that CHMI represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to CHMI. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with CHMI, then investors would naturally value CHMI at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with CHMI, investors would also value CHMI at a lower price since it is a lower growth investment. Both scenarios would explain why CHMI has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing CHMI to are fairly valued by the market. If this assumption does not hold true, CHMI’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of CHMI to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in CHMI, 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 Cherry Hill Mortgage Investment 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.