In my biography I highlight how my investment ideas tend to focus on companies where I believe the stock market is underappreciating the medium-term earnings potential of a business and/or its quality of operations. In this blog I will illustrate the simple theory that runs behind this, followed with a live example.
For the vast majority of companies, we can break down the share price into two components:
In financial jargon, this is equivalent to saying the share price is equal to the expected earnings multiplied by the price-to-earnings (p/e) multiple that the stock market applies to those earnings.
In a similar vein, the change in a company’s share price can be thought of as a function of the change in valuation (p/e) and the change in estimated earnings.
For example, Company ‘A’ shares are priced at £100 and expected to generate £10 in earnings next year. Its valuation (p/e) will therefore be 10x (=100 / 10). Suppose that midway through the year, Company ‘A’ releases a new product with exciting growth potential. Market expectations for earnings move up to £15 and, because of the longer term potential of this new product, the valuation also moves up from 10x to 15x p/e. In this event the shares would now be worth £225 (15 earnings x 15 p/e).
The stock market’s estimated earnings for any company are often referred to as the ‘consensus’, which is formed by sell side analysts who model and publish forecasts. One question I ask myself when I look at a new company is whether it can outperform consensus (e.g. can the company achieve £15, when consensus expects £10?). This involves analysing a company’s growth opportunities and risks, as well as its profitability, and comparing this to what consensus is assuming.
There are a number of factors I consider when estimating the appropriate valuation for a company. Most important are the ‘quality’ aspects of a business, which include the strength of the management team, barriers to entry, pricing power, profitability, capital intensity, as well as others. Most of the time, a high quality business should command a higher valuation than a lower quality business. Hence the other question I ask myself when I look at a business is whether I believe its valuation is too low (e.g. should it be valued at 15x p/e rather than 10x?). To aid in this I can compare the current valuation to its peers, the market, or even its own history.
As a real world example, let’s examine Asos1, a company which has seen significant share price volatility over the past few years.
In 2014, the shares peaked at £70 when consensus expected £0.7 in earnings, making for a very punchy (100x p/e) valuation. This high valuation was explained by market expectations for very strong revenue and margin growth.
As 2014 progressed a number of issues became apparent at Asos, such as underinvestment in systems and infrastructure and the negative impact the appreciation of the Pound was having on their international business. As a result both earnings estimates and the valuation fell simultaneously. The shares collapsed all the way to £25, reflecting a much lower £0.45 earnings estimate and 45x p/e multiple.
At this point, Asos looked a much more attractive investment. Its valuation was the lowest it had been in years, both on an absolute basis and relative to peers, while consensus expected more realistic earnings growth. There was an argument the company had rectified the issues it faced in 2014, a new management team had been installed, and the business was returning to growth. After analysing the situation, it became apparent to me that there was ample scope for both the valuation and earnings to increase. Fast forward to today and the company has continued to make encouraging progress with improved earnings and a notably higher share price.
In summary, I believe it is the interplay between valuation and earnings estimates that ultimately drives share prices. Taking a different view to consensus on this is what forms the foundation of any investment case. This should be true whether you are a value investor or a growth investor, with the difference being that value investors tend to focus more on the valuation side of the equation, whilst growth investors focus on the estimated earnings part.
1. This is no recommendation to buy or sell any particular security