March 26, 2020

North American Equities: What’s Priced In?

by Tim Gaumer.

“What’s priced in?” is a question being asked a lot these days. How much of this current and future bad news is now fully reflected in stock prices? Is it time to start bargain shopping?

It would be a fool’s errand to answer these questions now with so much uncertainty facing markets. However, we can share with you a tool that can help look at current growth rates now priced in.

To do this, we turn to the StarMine Intrinsic Valuation model. Used conventionally, this is a three-stage Dividend Discount Model that uses sell-side estimates for individual equities, adjusts those according to analyst accuracy and the age of the estimate (which we have named the SmartEstimate™) and then for analyst bias. There is an optimism bias in most estimates, especially in the forecasts for fast growing companies and estimates that are further into the future. The resulting bias-adjusted EPS growth rates are then converted into a string of dividends and discounted back to the present to calculate Intrinsic Value (IV). This is how Warren Buffett might value a company – by its inherent value, rather than relative to peers or by its P/E ratio.

For this exercise, we’ll use the alternative calculation this quantitative model generates – Market Implied Growth (MIG). To derive this, it uses the IV framework to solve backwards. It sets the last closing price as “fair value” then solves for the growth rate required to justify that price. In using this, you can begin to contrast your expectations for growth to market expectations and answer the question, ‘How much growth is currently priced in.’

Market Implied Growth can be examined at both the individual company level and in aggregate. We’ll begin by looking at the TRBC Business Sector level, sorted from lowest growth up. Exhibit 1 shows those with the most pessimistic MIG rates and against the 4-week price change. The universe is the S&P 500 constituents.

As you can see, the market has priced in a sharp contraction in growth expectations with negative 5-year compounded annual growth rates. In other words, these are the percentage declines EPS would have to decline by each year, for the next five years, to justify the current price. Given the recent swoon in oil prices, it’s not surprising to see energy near the top of this list.

Exhibit 1: Top 10 Business Sectors with the lowest market expectations for growth rates (March 25, 2020)

Source: Eikon by Refinitiv, StarMine

At the individual company level, the results become much more extreme. There appears to be a huge amount of pessimism priced into the expected growth rates of companies shown in Exhibit 2. You can see that reflected in their 4-week price changes, too. Sorting a large collection of stocks from low to high like this might uncover territory that brave deep value investors may be tempted to explore.

However, this comes with a warning – some companies in these cheap-appearing sectors may be cheap for a reason. For example, given plummeting oil prices, some energy companies may now have negative cash flows, low interest coverage, and a large debt burden. That combination is not sustainable long-term. It’s important to consider the balance sheet, too – especially during current economic conditions. Watch for an upcoming post on how to use other StarMine models and Eikon Apps to help separate true values from potential value traps.

Exhibit 2: Top 15 S&P 500 companies with the lowest market expectations for growth rates

Source: Eikon by Refinitiv, StarMine

At the other extreme, Exhibit 3 shows high-expectations companies. The challenge for analysts is to determine whether these stocks have held up better because of high quality and defensible business models and high long-term growth prospects or if expectations remain too high.

Exhibit 3: Top 15 S&P 500 companies with the highest market expectations for growth rates

Source: Eikon by Refinitiv, StarMine

Attempting stock selection in a market environment such as this one cannot possibly be easy, and the question of the appropriate level of growth can be answered only in hindsight. However, armed with this tool and Eikon Apps, investors can at least begin to discover what’s already been priced in and have a benchmark of comparison for their own growth expectations. Investors can make great returns during market recoveries. But doing so requires expectations that are different from market expectations (and ultimately closer to correct). There are few places they can go to compare their expectations to market expectations. The StarMine Intrinsic Valuation model and its Market Implied Growth calculations is one such place.

Briefly, here’s how you can do this analysis:

Exhibit 1 was built within the Eikon Aggregates App (type AGGR into the search box). From among many possible options, set the Universe to S&P 500, Rows to TRBC Business Sectors and Columns to Metrics. Add the column Fields IV Market Implied 5Year EPS CAGR and 4-week Price PCT Change. Sort any column simply by clicking on the metric name. Click again to sort in the other direction (high-to-low or low-to-high).

Exhibits 2 and 3 were built using the Eikon Screener App (SCREENER). Set the universe to the constituents of the S&P 500. No filters are used to screen out companies. In the Report section, add the MIG rate and price change columns, as in Aggregates, by typing the same field names into the Add Column box and sort in each direction by clicking the growth rate column heading.

The StarMine IV model and its components are also available as a feed for quants and in our quantitative analytics platforms: QA Direct and QA Cloud.

For a copy of the Intrinsic Valuation model white paper, which contains detailed model construction details and historical performance statistics, please contact your Refinitiv sales representative.

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