The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Sachem Capital Corp (NYSEMKT:SACH) is currently trading at a trailing P/E of 9.7x, which is lower than the industry average of 18.5x. While this makes SACH appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. 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 SACH
Price per share = $4.2
Earnings per share = $0.434
∴ Price-Earnings Ratio = $4.2 ÷ $0.434 = 9.7x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SACH, such as capital structure and profitability. 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.
SACH’s P/E of 9.7x is lower than its industry peers (18.5x), which implies that each dollar of SACH’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Mortgage companies in US including Solutions Group, Security National Financial and PennyMac Financial Services. As such, our analysis shows that SACH represents an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that SACH represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to SACH. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with SACH, then SACH’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with SACH, SACH’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing SACH to are fairly valued by the market. If this assumption is violated, SACH’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
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 SACH 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for SACH’s future growth? Take a look at our free research report of analyst consensus for SACH’s outlook.
- Financial Health: Are SACH’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.