Despite Its High P/E Ratio, Is Atrium Mortgage Investment Corporation (TSE:AI) Still Undervalued?

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Atrium Mortgage Investment Corporation's (TSE:AI), to help you decide if the stock is worth further research. What is Atrium Mortgage Investment's P/E ratio? Well, based on the last twelve months it is 14.21. That corresponds to an earnings yield of approximately 7.0%.

View our latest analysis for Atrium Mortgage Investment

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Atrium Mortgage Investment:

P/E of 14.21 = CA$13.83 ÷ CA$0.97 (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 Atrium Mortgage Investment's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. As you can see below Atrium Mortgage Investment has a P/E ratio that is fairly close for the average for the mortgage industry, which is 14.1.

Its P/E ratio suggests that Atrium Mortgage Investment shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Atrium Mortgage Investment actually outperforms its peers going forward, that should be a positive for the share price. I would further inform my view by checking insider buying and selling., among other things.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Atrium Mortgage Investment's earnings per share grew by -2.2% in the last twelve months. And it has bolstered its earnings per share by 1.4% per year over the last five years.

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

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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.

Atrium Mortgage Investment's Balance Sheet

Net debt totals 56% of Atrium Mortgage Investment's market cap. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.

The Bottom Line On Atrium Mortgage Investment's P/E Ratio

Atrium Mortgage Investment has a P/E of 14.2. That's around the same as the average in the CA market, which is 14.8. It has significant debt, though the market seems to take confidence from recent earnings growth.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

You might be able to find a better buy than Atrium Mortgage Investment. 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).

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.

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. Thank you for reading.