My discussions with a variety of market participants in the past couple of weeks indicate that we are at a stage in the market cycle when the investors and analysts begin to change their valuation arguments. Extrapolation of one-quarter performance to the next ten years, “story” pages of corporate presentations, political visions of growth, etc. begin to dominate the assumptions in the valuation matrices. Three to five years of forward earnings are being considered for arriving at twelve-month price targets.
My experience of the past three and half decades suggests that this kind of deviation always leads to mispricing of stocks and eventual sharp corrections.
It is important to remember that the return on the investment in publicly traded equities is a function of three factors: (a) earnings growth; (b) changes in price earnings (PE) ratio and (c) dividend.
The earnings growth is a function of multiple factors, e.g., (a) capacity (production capability); (b) demand environment (market leadership); (c) competitive landscape (pricing power, cost advantage); (d) innovation and technology advantage; (e) resource availability (raw material, labor, capital, managerial bandwidth, etc.), etc.
Price-earnings ratio (PER)
The price-earnings ratio (PER), one of the most popular equity valuation criteria, is the ratio between the earnings of a company and its market value. It broadly signifies that at the current rate of earnings how many years it will take for the company to add the value that an investor is paying today. Principally, an acceptable PER for a company's stock is defined by (a) the return on equity or capital employed (RoE or RoCE) a company is able to generate on a sustainable basis and (b) the growth rate of earnings that could be achieved on a sustainable basis. A company that could generate higher RoE/RoCE consistently and is likely to grow faster, is usually assigned a higher PER as compared to the ones that generate lower RoE/RoCE or have low or highly cyclical earnings growth.
Re-Rating
A rise in PER, if not commensurate with the rise in earnings profile needs deeper scrutiny. Sometimes the rise in PER occurs due to correction in anomalies (undervaluation) of the past. This is a welcome move. Sometimes, PER changes (re-rates) due to relative forces, e.g., a rise of PER in comparable foreign markets or a change in the return profile of alternative assets like bonds, gold, real estate, etc. This is usually unsustainable and therefore a short-term phenomenon. Many times, demand-supply mismatch in publicly traded equities also drives the re-rating of PER (excess liquidity chasing few stocks and vice versa). This is again usually a short-term phenomenon.
Dividend
A sustainable rise in dividend yield could be a sign of improvement in (i) profitability; (ii) stronger financial position (B/S improvement by deleveraging); and/or (iii) stronger cash flows. In some cases, however, it could reflect stagnation in growth. Investors need to assess the reasons behind higher dividend yield before getting lured by it. A higher dividend for lack of growth/reinvestment opportunities would often lead to the de-rating of PER, thus reducing overall return for investors.
No comments:
Post a Comment