Making sense of speculative stock hysteria

Speculative stocks tend to rise whenever the PSE index falls and when share prices of blue-chip stocks go up, speculative trading tends to become less active.

This inverse relationship has never been more negative lately when the market started to fall from a record high in January. The number of traded dormant stocks, mostly negatively correlated to PSEi, rose to 26 percent from 19 percent last year.

Such market behavior is common in a bullish market where investors tolerate riskier stocks after taking profits from large cap stocks.

Speculative stocks are known as risky stocks because they don’t have history of profitability or positive cash flow. They rise based on market perception on what the company could possibly do in the future.

This is what drives investors to speculate, given the promise of windfall profits from higher stock prices. The more credible the story, the greater the conviction in the price appreciation.

But the risk is also high that the speculation would not materialize, which could lead to massive trading losses.

Remember that share prices rise and fall based on expectations. Market players speculate on how much the stock should be worth in the future when expectations are met.

As most speculative stocks are not profitable or have historically low income or sales, typical valuation metrics such as price-to-earnings (P/E) or price-to-sales (P/S) ratio are not applicable.

Let’s take the case of Now Corp. whose stock price has risen by as much as 600 percent from P2.86 to P20 per share within a few weeks on speculations that it might win the bidding for the third telco slot.

At current share price of P13.08, NOW is trading at a ridiculously high P/E ratio of 785x based on historical earnings. Investors buy the stock based on potential earnings from assets that it will acquire in the future.

This means, the share price of NOW that speculators are willing to pay represents the present value of all the future earnings the company is expected to generate, discounted by an appropriate risk-adjusted rate.

The risk adjusted rate is the difference between the minimum return that any investor will require from the stock minus the expected growth rate. If the speculative stock is perceived to be risky, investor will require higher return and growth rate.

A quick and dirty way of computing this is to estimate the minimum return by adding a risk premium on the 10-year Philippine bond yield of 6.8 percent and reduce it by growth rate. The risk adjusted rate for NOW is estimated at 4.8 percent.

This means that for every one peso of earnings in future discounted by 4.8 percent risk adjusted rate, the implied P/E ratio of NOW stands at 20.7x.

If NOW fails to win the bidding, the risk premium will increase, raising the minimum return while the expected growth rate falls, resulting in higher risk adjusted rate.

Let’s say the rate tripled to 14.4 percent due to market disappointment, the speculative P/E of NOW will fall to 6.9x, bringing down your target share price.

If NOW wins the bidding, the stock will become less risky with lower risk premium. With more details about the earnings that will come on stream, expected growth rate may also increase.

These two variables will result in lower risk adjusted rate, which raises speculative P/E, hence higher target share price.

Computing for risk adjusted rates can also be used to determine which among the bubble-like stocks are relatively “cheap” based on the probability of fulfilling market speculations.

A lower implied P/E by comparison means the stock has bigger room for increase relative to other speculative stocks in the basket. Among speculative P/E ratios in the basket are: MRC Allied, 22.4x; PXP, Energy 17.7x; Golden Haven, 40.2x; APC Group,19.6x; Vulcan Mining 17.3x and ATN Holdings,184x.

Be aware that this lazy way of estimating implied P/E ratios does not validate the fair value of any speculative stock. It takes loads of assumptions to determine the intrinsic value of a stock and this is only possible when more information are disclosed.