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American Home Mortgage (AHM) is paying the piper this morning. An earnings update for Q1 yesterday, lowering the target from $1.06 to $0.40-$0.60 and cutting dividends, seems to have taken the stock down 16%.

My first reaction was : WHAT? Only 16%!!?

Never mind the fact that, using the vaunted discounted cash flow/earnings or whatever method that sums up the projection, this number would be at most HALF of the current equity value.

Never mind that the halving of the earnings is made at the beginning of current stress period. - or the horrible housing market condition in large Alt-A market such as California (see here for the latest news.)

Never mind that equity risk premium, given the lowered cashflow estimates, should also be much larger - given the asymmetry in returns: negative outcomes outweigh the positives.

The forward P/E essentially doubled yesterday morning, which makes it look cheaper, but not cheap enough at P/E of 13 (from 6.5) given the risks-reward profile.

The million dollar question is, who's next. I think it is Indymac (NDE). Their forward P/E is 9. If Indymac were updating their estimate today a la AHM, then that P/E is 18. Maybe stockholders should not worry, though. The market is extremely generous and doubling the P/E corresponds to only 16% drop in stock price. If that is the case, then perhaps moving your investment to a other companies that have "true" P/E of 9 will earn more market generosity. Countrywide Financial (CFC) also has a P/E of 9, and they are much more diversified (Prime, Alt-A, and Subprime Mix).

NDE/CFC 1-yr comparison chart
NDE CFC

In the end, the question is relative value around risk asymmetry. Both have the same earnings expectation, but one has a much larger downside risk. In a balanced world, that large downside risk can just be expressed as risk premium. In an unbalanced world where the housing market clearly is heading one way - downwards - that risk premium should materialize into the actual price. AHM investors seem to learn of that the hard way yesterday, although I was actually surprised how little of that materialization is observed.

Disclosure: Author holds a long position in CFC

Source: Who's Next After American Home Mortgage?