How Much Premium Should You Pay For Earnings Growth?
It has always been said that the reason why some stocks trade at high P/E multiple is because investors are willing to pay a large premium for companies with solid earnings growth.
Blue chip stocks such as Ayala Land, Jollibee, SM Prime Holdings and Universal Robina have historically enjoyed high P/E ratios because they were perceived to be reliable.
Investing in stocks with a track record of steady earnings growth means less chances of losing. The lower investment risk resulting from a predictable earnings growth is the premium that investors pay for.
While reliability deserves some premium, market perception can overpay a stock that even the most dependable blue chip in the market can become dangerously overvalued.
Valuing D&L Industries. Let’s use a simple valuation model to illustrate the stock premium of D&L Industries using the stock’s historical return on capital of 18.9 percent and cost of capital of 10.75 percent.
For D&L to achieve its earnings growth target, it needs to reinvest a portion of its earnings in its business. If D&L expects its earnings to grow by 9.5 percent, the company needs to reinvest 50 percent of its earnings back for its expansion.
The 50 percent reinvestment rate is derived by dividing the target growth rate of 9.5 percent with the company’s return on capital of 18.9 percent.
Now, the value of a stock can be estimated by taking the present value of a company’s future free cash flows. This is computed by following this simple formula: free cash flow / (cost of capital – growth rate).
If the expected cash earnings of D&L this year is P3.5 billion, you need to get the free cash flow by taking out the reinvestment portion of 50 percent to derive the amount of P1.7 billion.
To value the stock of D&L, simply divide the free cash flow of P1.7 billion by the difference between the cost of capital of 10.75 percent and expected growth rate of 9.5 percent to project a market valuation of P140 billion.
If the market is confident that D&L will deliver earnings growth target of 9.5 percent, the stock’s premium can be expected to further appreciate from the current 34x P/E to 55x P/E to achieve the P140-billion market capitalization.
When does premium become too much?
Let’s consider another scenario. Assume that the earnings growth target will still be 9.5 percent but this time, the return on capital of D&L will be made equal to its cost of capital at 10.75 percent. At this rate, D&L will need to increase its budget for reinvestment at 88 percent from 50 percent.
With a reinvestment rate of 88 percent, what will remain as free cash flow from P3.5 billion will only be P412 million. To value the stock using the same formula above, D&L’s projected market capitalization will fall to P33 billion or 11x P/E, making the current share price of the stock at 34x P/E grossly overvalued.
What determines premium?
This admittedly crude valuation model tells us that a fair premium cannot be achieved solely on the basis of perceived earnings growth. You need to justify paying a premium for a stock by examining the ability of the company to generate positive returns on investment over its cost of capital.
When a company is achieving positive net return, it means that it is creating value for its shareholders. The higher the excess returns, the higher the premium.
When is premium not justified?
No matter how aggressive the projected earnings growth of a stock is, if the company is expected to earn just enough to cover its cost of capital, no amount of premium can justify a high share price. This stock will not be able to sustain a high P/E multiple if ever and will always revert back to market average.
It may come as a surprise to some people to know that there are various stocks in the market, including those in the PSE index that do not generate enough returns against its cost of capital.
Many investors are not aware that many of these stocks do not deserve to trade at a premium and are considered overvalued based on valuation. Avoid paying premium for a stock by doing your research before investing.
It pays to examine the historical returns and cost of capital of a stock to know how much premium you should pay.
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools are provided by First Metro Securities. To learn more about stock valuation and analysis, attend the 11th Accredited Financial Analyst (AFA) program this May 2017.
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