How to value stock growth expectations

Stock prices rise and fall based on expectations. When market expects earnings to grow, stock prices rise and when earnings disappoint, stock prices fall.

Some stocks enjoy high price-to-earnings (P/E) ratios because investors are willing to pay premium for their earnings track record, while other stocks trade at significantly high valuations because investors anticipate them to grow faster than the average.

Market perception plays an important role in pricing a stock but investing in a stock based on perceived future growth alone can be risky.

When market is strong, investors tend to overpay stocks that even the most dependable blue chip in the market can become dangerously overvalued. When market is weak, investors tend to underprice poorly perceived stocks.

How do we measure market perception of a stock’s growth potential?

Remember that the price of a stock represents market expectations about the future growth of its earnings. To value growth expectations of the stock, we need to break down the stock price into two parts.

The first part represents the value of the “assets-in-place” and for the second part, the value of growth opportunities. Valuing the first part of the stock price assumes that the annual earnings from existing assets will be distributed as dividends, leaving nothing in the company for future growth.

Let’s take the case of Ayala Land (ALI). To value ALI’s existing assets under a no-growth assumption, simply discount the company’s earnings, as represented by its trailing earnings per share of P1.77 by its hurdle rate of 12.5 percent to derive P14.13 per share.

A hurdle rate is the minimum rate that a company expects to earn from existing assets. This is computed by taking the risk-free rate, where in this case we assume 6.8 percent from the 10-year Philippine bond yield plus market premium of 5.7 percent as adjusted by the stock’s beta.

To get the value of ALI’s growth opportunities, deduct the computed value of “assets-in-place” of P14.13 per share from its market price of P42.90 to derive P28.7 per share. The amount, which is 67.1 percent of ALI’s share price, represents market perception of ALI’s future growth.

The value of growth accounts for about 48 percent of market prices of the 30 stocks belonging to the PSE Index. Among stocks that have high market growth expectations are Jollibee, 75.8 percent; SM Investments, 78.9 percent; SM Prime, 80.7 percent, Universal Robina, 72.2 percent and Ayala Corp, 61 percent.

The value of growth accounts for median of 54.8 percent of the market values of 300 plus listed companies. About 22 percent of stocks in the PSE have growth values accounting for more than 100 percent of their prices because they have negative earnings and are mostly speculative.

Another 20 percent of stocks belong to the profitable companies that have growth values greater than the median of 54.8 percent. Among these are San Miguel Food and Beverage, 85.2 percent; Chelsea Logistics, 87.7 percent; Double Dragon, 77.6 percent; Macroasia, 67.8 percent; Wilcon, 65.9 percent and D&L, 59.1 percent.

Note that the greater the market expectations, the higher the share prices go, but in a market where there are uncertainties with slowing economy and rising inflation, the hurdle rate may also go up, which may lower the value of existing assets.

When hurdle rates increase, share prices tend to fall because the value of growth portion enlarges to the point beyond rational expectations.

Some stocks with history of reliable earnings growth, however, have the capacity to absorb higher hurdle rates because they have lower perceived risks, enabling them to enjoy higher growth value in their share price.

Understanding how the value of a stock price interact with growth and risks can help in validating how much premium one should pay based on market perception and fundamentals.