Stock prices rise and fall based on market expectations.
This growth expectation is incorporated into the share price of a stock whose price-to-earnings (P/E) multiple may result in a premium or discount to market average.
There are stocks that trade at relatively high P/E ratios because the market believes that these companies will deliver on their promises. And there are also stocks that trade at huge discounts because they have fallen out of favor with the market.
But how do we know if the market is being overoptimistic? One way to examine this is by comparing market expectations with the implied growth rate of the stock based on its current P/E ratio.
The implied growth rate can be derived by first getting the difference between the desired return on investment and the earnings yield, which is the inverse of the stock’s P/E ratio.
After which, the difference shall be divided by the sum of the earnings yield plus one.
To illustrate, let’s take the case of Jollibee.
The earnings yield of the stock stands at 2.6 percent, which is derived by simply dividing one over the current P/E ratio of 38x.
The earnings yield of 2.6 percent shall be subtracted from the minimum return on investing in Jollibee at 8.7 percent, which brings 6.1 percent. This figure shall then be divided by 1.026 to get the implied growth rate of Jollibee at 5.9 percent.
The minimum return of 8.7 percent, which is used to compensate for the riskiness of the investment, is computed by adding risk premium of 3.1 percent of the stock over current interest rate of 10-year fixed rate Treasury note at 5.6 percent.
This exercise tells us that in order to earn the minimum return of 8.7 percent by buying Jollibee stock at current P/E of 38x, the company’s earnings must grow by at least 5.9 percent next year.
Theoretically, if the earnings of Jollibee grow by more than 5.9 percent next year, share price should go up and the returns on investment shall be in excess of 8.7 percent.
Looking back, as the year-end approaches, the stock market, represented by the PSE index, started the year with an implied growth rate of 4.1 percent.
The actual average growth of 16 percent in corporate earnings for the past 12 months was way above the expected growth.
This has fueled the PSE index to gain 19 percent this year, higher than the minimum return of 10.2 percent in the market.
With interest rates rising from 4.6 percent at the start of the year to 5.6 percent this month, the average minimum return to earn in the market also increases to 11.4 percent.
The increase in riskiness as a result of higher required return would have sent the PSE index to fall by as much as 15 percent if the market expects the same long-term growth rate of 4.1 percent next year.
But because economic outlook remains robust next year, investors expect earnings to grow higher. Current level of the stock market, despite having corrected by 4 percent recently, shows investors stay positive with higher implied growth rate of 5.1 percent next year.
Unless there are unforeseen factors that may increase riskiness of investing in stocks such as uncontrollable rise in interest rates or political uncertainties that slow down the domestic economy, expectations of higher earnings growth should lead to higher share prices next year.