Should you overpay for high growth stocks?
Q: My broker has been suggesting that I buy Double Dragon and Xurpas. But I find their share prices expensive and I cannot understand why the market is buying these stocks aggressively when everything else is falling. I am confused.—Jay C Yolo by email
In a bearish market where share prices are more likely to fall, it takes a lot of courage to go against the trend and follow the crowd by chasing stocks at record high prices. It can be a very risky move if you don’t have any fundamental basis because you could be buying an extremely overvalued stock. But if you believe that the stock has strong growth prospects and will outperform in the long-term despite its seemingly expensive valuation today, you can manage your risks by learning more about the company and its future plans before you invest.
Why do investors like the stock? Why does the stock enjoy such a high premium in terms of earnings multiple? Does it have high earnings growth potential? How likely can the stock sustain its earnings growth? Will the growth be coming from organic expansion? Acquisitions? Joint venture with strategic partners? How confident are you that the plans will be carried through?
Stocks rise and fall based on market expectations. If the market is optimistic about a stock’s earnings outlook, the stock will go up, and when it is pessimistic and nervous, the stock price will fall. Market players constantly assess their risks based on expectations, which are anchored on the long-term prospects of the stock and the stock market in general. This positive expectation about the future is what makes investors pay premium for a stock. The premium extends beyond the current earnings outlook. It also incorporates the potential earnings the company will make a few years from now given its commitment and resources.
How do you quantify this expectation into the intrinsic value of a stock? One way to do this is to get the present value of the future earnings of the company and multiply this with an appropriate PE multiple to derive the target share price. For example, Xurpas is currently trading at PE multiple of 66x. The stock may look extremely overvalued given the market PE average of only 17x at the moment. But the company has been forging strategic partnerships by buying stakes in several companies such as Games platform Matchme, US-based startup Quick.ly and local software firm Seer as part of its effort to strengthen its capability to expand its services in the Asian region.
Just recently, Xurpas also acquired a controlling stake of 51 percent in Yondu in partnership with Globe Telecom, effectively more than doubling its revenues and boosting its earnings base by at least 50 percent. With this outlook, let’s assume that as a result of the synergy created by Xurpas’ acquisitions, earnings will grow by 50 percent annually in the next five years. By that time, the projected earnings will be about P2.4 billion or P1.36 per share. Let’s assume that the target rate of return by investors is 7 percent. To bring the projected earnings per share of P1.36 to present value, simply divide this figure by the target rate of 7 percent five times from the fifth year to derive P0.97 per share. Multiply this by 18x PE, the same multiple used in valuing the company when it went IPO last year and you will arrive at intrinsic share price of P17.50. At this target price, the current share price of Xurpas will look grossly undervalued with a 31-percent discount.
In case you cannot project earnings immediately, you can use the revenue multiple approach based on enterprise value. Enterprise value (EV) is calculated as the equity value of the company plus its long-term debt minus total cash. Let’s use Double Dragon (DD) as example. This stock is currently trad ing at 78x PE and it looks very expensive anyway you look at it. But if you will look deeper at what the company plans to do in the immediate future, you will see that it plans to open 20 community malls in partnership with SM Group next year. DD plans to have a total of 100 community malls in five years as part of its long-term plan to achieve leasable area of one million square meters. To project its revenues on the fifth year, assume current lease rate of P500 per sqm to escalate by 5 percent annually and multiply this with one million square meters to get projected annual revenues of P7.7 billion. To value the company, apply the EV to revenue multiple of 11.6x, which is the sector average for similar mall based companies like SM Prime, Ayala Land and Robinsons on the projected revenues of P7.7 billion to derive EV on the fifth year at P89 billion. To bring this to present value, discount this with target rate of 7 percent to get P63 billion. Minus this by the company’s current debt of P12 billion and add back total cash of P4 billion, you will get equity value of P55 billion or an intrinsic value of P24.64 per share. At this valuation, current share price of DD will look undervalued by 12 percent.
Note that these intrinsic values represent the perceived values of the stocks based on the assumptions made by the investor. It is likely that these values may change later on depending on the changes in level of market risks. For example, if interest rate increases, the target rate of return may also increase from 7 percent to 10 percent, which may lower valuation that could prompt investors to take profits on the stocks.
Yes, you can pay premium on a stock if you know the underlying intrinsic value. But in a volatile market like this, it will be best to buy these stocks after it has settled down.
Henry Ong is Registered Financial Planner of RFP Philippines. To learn more about equity valuation, attend the 6th Accredited Financial Analyst (AFA) program on Oct. 17-Nov. 28. To inquire, email [email protected] or text <name><email><AFA> at 0917-9689774
