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Money Matters

How market perceptions affect stock prices

/ 05:12 AM September 19, 2018

It has been said that the value of a stock is a reflection of investors’ perceptions about the growth prospects of a company. The greater the growth expectations, the higher the value of the stock should be.

In my recent column “How to value stock growth expectations” several weeks ago, I explained that the value of a stock price consists of two components, namely, the value of assets-in-place representing the no-growth portion and the value of expected growth.

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When a share price increases, the portion of the expected growth value also increases while keeping the value of assets-in-place constant. However, when uncertainty arises, such as escalating inflation and rising interest rates, the risk to invest in stocks also increase, which raises the investors’ hurdle rate.

A higher hurdle rate tends to lower the no-growth portion of the stock, which in turn enlarges the portion of the expected growth value. When the growth portion of a stock goes higher than what the market expects, the share price of the stock tends to fall.

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But how do we know if the market is too optimistic or pessimistic over a stock’s growth potential?

One way to measure market expectations is by estimating the implied growth rate of a stock based on the perceived growth value.

Let’s take the case of Puregold (PGOLD). The minimum value of the company today assuming there is no growth is estimated at P22.36 a share.

At current share price of P45, the value of expected growth embedded in the share price is P22.64 per share or 50 percent of market value.

For the stock to grow from no-growth value of P22.36 a share to P45 assuming a five-year time horizon, the implied compounded annual growth rate (CAGR) of earnings must be 15 percent.

This implied growth rate will not mean anything until we compare this to a benchmark. The historical annual growth rate of PGOLD for the last five years is 17 percent.

At the current share price of the stock, we can say that the growth expectations of the market on PGOLD may be a little bit pessimistic because its implied growth rate of 15 percent falls below its minimum historical growth of 17 percent.

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Is the market pessimism on PGOLD valid? If there were recent changes in the company that increased the risks of the stock resulting in slowing earnings growth, then there must be a good reason for the market to be negative.

But if there is nothing wrong with the fundamentals as the low implied growth rate may have been caused mainly by poor market sentiment on share price, then the stock may be undervalued.

Currently, the median implied growth rate in the market is about 13 percent against historical growth rate of 9 percent. This is also higher than the analysts’ median growth estimate of 11 percent.

While the market appears to be optimistic despite the bearish mood, the implied growth rate of 13 percent also shows the market is still far from bargain levels. Will the PSE Index fall further in coming weeks or a strong recovery is already underway on market optimism?

Amid the positive growth outlook of the market, it is interesting to note that about 43 percent of the 30 stocks belonging to the PSE Index have implied growth rates that are lower than their historical benchmarks.

These stocks merit a second look if the market’s pessimistic outlook on their growth expectations is rational. Among the notable ones include Ayala Corp, which has implied growth rate of 19 percent against historical CAGR of 24 percent, yielding  a net of -5 percent; DMCI, -6 percent; GT Capital, -8 percent and Robinsons Retail, -19 percent.

There are also stocks that the market expects a negative growth despite solid historical growth record in the past.

Petron, for example, has implied negative growth rate of 6 percent against historical CAGR of 50 percent, while Semirara Mining has historical CAGR of 17 percent but market expects negative 5 percent growth. Is there an opportunity for value investing here?

Market perception can create reality into the share price, but only the reality of growth can shape perception of long-term share price appreciation.

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