Numerators and Denominators
On Valuations and Earnings
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Ah, the end of a Quarter.
It’s that time of the year again when analysts come out with price targets on entire indices and we position towards what we think will happen in H2.
I always wondered why they would bother with so many different components and moving parts. Applying a blanket earnings number multiplied by a P/E multiple to get a target price seems like a pretty arbitrary exercise to me.
However, while slapping some sort of well-rounded figure up there might seem like a futile target, I think there are great lessons and insights to be gained from the two components that make up price: Sentimental and Fundamental.
There are also many interesting takeaways for those that focus on risk-adjusted returns as they sharpen their pencils while preparing to make big calls. Spec tech names are down 75%+ — how much more can they really go? Did oil run too hot? What about the housing market, since the builders are getting crushed more than REITs — is there a value play there?
The first half of 2022 has seen so many reversals of trends that have dominated the last couple of decades. Value finally made a comeback on growth. Inflation broke aggressively above the 0-5% band that it had kept in since the early 1980s. Stocks do not, in fact, only go up, as spec tech came crashing down. And an industry that was supposed to be in “secular decline” made a fantastical comeback as it appears we should never have left our energy policy in the hands of a Swedish teenager.
This week, in <5 minutes, we’ll cover Valuation levels into earnings:
Valuations 👉 Thinking through Sentimental x Fundamental
Multiple Compression 👉 We’ve been here before
Earnings 👉 The hurdle left to clear
Let’s get started!
1. Valuations 👉 Thinking Through Sentimental x Fundamental
Prices of stocks are made up of two components. Fundamental and Sentimental.
Fundamental x Sentimental = Stock Price
Fundamentals are attributes that you can see on the company’s quarterly filings - things like revenue, gross margins, EBITDA, free cash flow, net income, and book value.
Sell-side analysts will build out models to project what growth should look like over the next several years. Usually, analyst models will only go 3 years into the future before becoming too much of a shot in the dark. Unless it’s a DCF that will build out 10 years in advance then discount both a terminal value and free cash flows back to the present in order to arrive at a target price.
You can see why a 3-year model is more valuable for a company like Tesla, and why a 10-year DCF might make more sense on a portfolio of residential apartments.
When analysts are building out these models, they usually rely heavily on the management team to provide accurate and timely information so that the market isn’t thrown for a loop come earnings time.
In periods of relative economic stability in a slow grind up and to the right, earnings estimates tend to be very accurate, and any alpha generated around earnings period is extremely difficult to ascertain unless a major event is uncovered.
Major events could include something like a major customer dropping off, a warehouse fire destroying inventory, or something like say… a pandemic and a war.
Times of turmoil make earnings forecasts extremely important and we are smack in the middle of this.
The other component is Sentimental. This is how you are pricing future growth and is primarily made up of two parts: the story that the company can tell and the global macroeconomic environment.
The story is important because if you have a charismatic founder with integrity (AKA someone you would “go to war” with) then they can tell a story of growth that investors will believe. If the founder has deep expertise in a field and has uncovered an opportunity with phenomenal growth, you will pay more to participate in the upside versus say a Coca-Cola that has been around for years with more or less predictable growth rates.
The best example of a story well told was Adam Neumann to Masa Son. If you haven’t seen WeCrashed on AppleTV it’s worth grabbing the free trial and going for a binge. Adam Neumann told such a wonderful story that fooled many investors into buying a dream instead of a reality. It was all a total crock of shit but really fascinating to see the cult mentality.
The other component of Sentimental is the macroeconomic environment. For instance, a very important factor in a lot of economic models is the concept of expectations. When you were drawing your supply and demand curves back in Econ 101, “expected” turns up all the time. The reason is that rational human beings shift their consumption behavior around how they think the future will unfold.
Since the economy is just a compilation of individual demand and supply curves aggregated, expectations drive a lot of underlying pricing behaviors. If you think that a recession is coming, you will pare back on frivolous goods and contribute to a rainy day fund. If you think tough times are coming for your business, you will slow hiring and reduce headcount.
Everything ripples through.
So where have we been, where are we now, and where are we going when it comes to both fundamental components and sentimental components?
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2. Multiple Compression 👉 We’ve been here before
Over the course of extremely accommodative monetary policy what we’ve had is a lot of excess capital flow into equities. When you follow the flow of funds, more capital in the system usually leads to a generally elevated level of multiples.
Let’s look back to previous time periods from both a pure multiples level perspective as well as a percentage in multiples contraction.
When you first look at the percentage of multiples contraction, it is very much in line with past historical declines, with the exception of the crash back in ‘73/’74.
But when you first look at the overall level of multiples around that 20x on a TTM P/E basis in the S&P 500 it looks like there could be more compression to go.
I think it is important to think of multiples as an overall level than it is on a percentage contraction basis, but the contraction percentage here just highlights how much pain we are in.
This is the market really blowing off a lot of the fiscal stimulus hangover as the money that was pumped into the market is now leaving through restrictive policy as well as QT.
Before we continue, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!
3. Earnings 👉 The Hurdle Left to clear?
What a lot of people are looking for going into earnings season is the estimate revisions downwards. We’ve seen a couple of analysts hit the tape with across-the-board revisions down in their estimates even ahead of earnings, but some analysts are lazy and just do them the day after the most recent report (and rarely between quarters).
The reason this will be a critical component is that when you look at the multiples if the denominator (earnings) is coming down, the multiples will come back up - meaning their current levels are artificially “too low”.
For example, if a stock is priced at $100 and has $20 in the next twelve months (forward-looking) total earnings, the P/E ratio is 100/20 = 5x. However, since this particular stock will get hit by the recession, “real” forward earnings are closer to $10, meaning the P/E ratio will re-rate to 10x.
This revision of earnings lower across the board would mean that multiples are STILL TOO HIGH.
As we can see from this chart, we have yet to really experience that downturn in earnings revision as shown by the solid black line. However, there are some indications that we could be following a similar trajectory to what we saw during prior sell-offs of downward revisions.
Buckle up for earnings season.
While trying to grind out alpha come earnings season hasn’t been extremely effective in the past, in more volatile times it could be a viable strategy. While the macro narrative continues to dominate over the micro in the short term, doing your homework on industry-specific names and asking the right questions will give you a better overall picture in this environment.
Some checklist questions to ask:
How much pricing power does this company have in a recession?
What is the exposure of COGS to raw materials?
How will shrinking budgets and purchasing power in end customers (for both B2B and B2C businesses) affect sales pipelines?
and most importantly… How and when does CPI peak?
Now, some of these questions can be answered definitively while others take more analysis, guesswork, and instinct. Obtaining the right answers is crucial but at the end of the day, what we do with those answers is what really matters.
Every month, these are the types of questions, answers, and actions we are writing about to our paid subscribers, in-depth and in detail.
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Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
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What else we Grittin’ On?
STARTUPS. Global deal activity fell 23% between the first and second quarters of the year. VC funding is set to hit its lowest level since 2020.
DEFLATION. Cathie Wood says she got inflation wrong but actually we're headed for deflation. Also, we're already in a recession.
INFLOWS. Meanwhile, investors are rushing to Wood's flagship innovation fund. ARKK just posted it's longest inflows streak in over a year.
DIVDENDS. Four out of the six major US banks will boost dividend payments. The increases will take effect after the Fed's stress tests.
OIL CAP. G7 leaders are exploring a cap that would limit the price of Russian oil. OPEC+ is sticking to its planned output hikes in August.
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