The stock market kicked off the New Year with new record highs as expected from the strong January effect this year.
Last month, I mentioned in this column titled “How to profit from January effect?” that historically, stocks tend to rise strongly during the first week of the year with average returns of 3.9 percent as evidenced by 65 percent of the time for the past 20 years.
The PSE index gained 4.3 percent in the opening week and share prices are likely to advance further in the next few weeks with the current bullish momentum.
According to market beliefs, a strong January bodes well for the rest of the year but how sustainable is this uptrend in the coming months? At what stage can we say that stocks are overvalued and risky?
The most common way to determine relative valuation is the use of price-to-earnings (P/E) ratio. A stock is considered expensive when its P/E ratio is higher than the market P/E. The problem with this approach, however, is that not all stocks share the same risks.
The value of a stock is based on earning growth and risks. When a stock is perceived to be risky, investors tend to demand higher return. The higher the return, the lower the intrinsic value of the stock.
Another way to measure the upside potential of the market from the risk perspective is to get the excess returns between the implied returns of PSE index stocks based on current P/E ratios and the conventional required rate of returns.
The implied return can be computed by taking the earnings yield, which is the inverse of P/E ratio and adding the assumed long-term growth rate of earnings.
Let’s take the case of BDO. The stock has prospective P/E ratio of 21.9x. To compute the market-implied rate of return of the stock, simply inverse the P/E ratio to get earnings yield of 4.6 percent and add a long-term growth equal to GDP growth rate of 7 percent to derive a return of 11.6 percent.
This implied return of 11.6 percent represents the IRR or internal rate of return that discounts all future earnings of the stock to equal its current share price.
Imagine if the implied return increases, the value of the stock decreases, and vice versa. Since this rate is inferred by the market, mispricing is possible due to frequent trading of the stock and other factors.
In order to separate the effect of mispricing, it is necessary to compare the implied return of the stock with its conventional required rate of return.
The conventional way to compute the required rate of return is to add the risk premium of the stock, which is 4.0 percent over the risk-free rate, which is the 10-year fixed rate of treasury note of 5.7 percent, to derive a return of 9.7 percent.
A positive difference between implied returns and conventional returns indicates that the stock may be undervalued, and when conventional is higher than the implied, the stock may be considered overvalued.
Since BDO has an implied return of 11.6 percent, higher than its conventional rate of 9.7 percent, the excess return of 1.9 percent makes the stock potentially undervalued at current share price.
There are 18 out of 30 PSE index stocks that are underpriced by excess returns. The market as represented by the PSE index is considered fundamentally undervalued at current level, with median implied return of 12.8 percent as against conventional return of 11 percent.
Based on the conventional return of 11 percent using the dividend discount model, the target P/E ratio of the market is estimated at 25x. Unless there are changes in risk and growth assumptions, given the current forward P/E of 17x, the potential increase of 47 percent should sustain the PSE Index to reach 10,000 this year.