Understanding Future Implied Sales Growth Expectations:
AFG has a process in which our model “reverse engineers” what a company needs to deliver in sales growth over the next 5 years (assuming 5 Year Median Margins and Asset Turns) in order to justify its current trading price. Understanding these “expectations” for revenue growth embedded in a company’s current trading price are an important indicator in identifying undervalued companies and attractive segments of the market.
Essentially this Future Implied Sales Growth creates a “hurdle rate”, similar to an over/under line in a sporting event, to evaluate how likely a firm is to deliver the growth needed over the next 5 years in order to deliver adequate returns for its shareholders. In most circumstances, if the imbedded future performance is very conservative relative to the company’s historical growth or consensus/personal estimates for future growth, the stock is regarded as undervalued/attractive.
To further explain this theory we will provide company examples of firms with high and low expectations for Future Implied Sales Growth built in to their stock prices.
Cerner Corporation (NASDAQ:CERN): Low Expectations
When expectations are low (low hurdle rate) a company has a much easier time meeting the growth requirements to deliver adequate returns to its investors and thus, are more likely to outperform.
In the example below, Cerner Corporation (NASDAQ:CERN) needs to deliver around 5% sales growth over the next 5 years to justify its current trading levels. When you compare the Future Implied Sales Growth of 5% to what the company has delivered median growth of 19% over the previous 5 years. Our model also projects average growth of around 10% over the next 2 years. It seems very reasonable for Cerner Corp. to deliver the growth needed to provide a solid return for its investors.
Along with low expectations for sales growth “priced-in” to its trading price, Cerner Corp. also earns an AFG Investment Grade of “B” with solid marks for Valuation and Management Quality. Cerner Corp. has many of the characteristics we look for in attractive investment opportunities.
Nucor Corporation (NYSE:NUE): High Expectations
On the contrary, when implied sales expectations are high (high hurdle rate) for a company or index relative to what it has delivered historically, it becomes difficult to deliver the growth required for investors to obtain a satisfactory return on their investment.
In the second example, Nucor Corporation (NYSE:NUE), has delivered -2% median sales growth over the prior 5 year period and is projected to deliver around 3% sales growth on average in the next 2 years. It looks extremely unlikely that this firm will be able to deliver the 25% Future Implied Sales Growth built into the company’s current price.
Not only does NUE have a pretty large obstacle to clear as far as sales growth expectations, it also contains several other characteristics inherent in potential torpedo stocks and currently earns an AFG Investment Grade of “D”.