Cherry Hill Mortgage Investment Corporation (NYSE:CHMI) is currently trading at a trailing P/E of 3.2x, which is lower than the industry average of 9.9x. While CHMI might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Cherry Hill Mortgage Investment
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as 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 = $16.96
Earnings per share = $5.226
∴ Price-Earnings Ratio = $16.96 ÷ $5.226 = 3.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against 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. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
At 3.2x, CHMI’s P/E is lower than its industry peers (9.9x). This implies that investors are undervaluing each dollar of CHMI’s earnings. 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 “similar companies” are actually similar to CHMI. If the companies aren’t similar, the difference in P/E might be a result of 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:
Since you may have already conducted your due diligence on CHMI, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 CHMI’s future growth? Take a look at our free research report of analyst consensus for CHMI’s outlook.
- Financial Health: Is CHMI’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.