05/27/2017

Value Expectations – Are Expectations Getting Lofty for the S&P 500 Index?

Understanding the embedded expectations for sales growth (Implied Sales Growth) baked-in to a company’s trading price in relation to what the company has been able to deliver in sales growth historically, can be an important indicator of future performance. AFG’s Value Expectations interface essentially “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. The Implied Sales Growth then serves as the “Hurdle Rate” for the stock to determine how likely a firm will be to deliver the sales growth necessary to deliver adequate returns for investors. Companies with the highest hurdle rates have proven to be more likely to underperform than companies with realistic expectations for sales growth priced-in.

As an example we will take a look at Michael Kors (KORS) a company in our AFG50 model portfolio and a company with very low embedded expectations for sales growth. We will walk through a sensitivity analysis/stress test on KORS valuation levels using some different assumptions for sales growth within the VE interface. In the top table we are looking at the KORS on a long-term timeframe of 5 years, assuming EBITDA margins and asset turns remain constant at reasonable levels, KORS needs to deliver around -7% sales growth on average over the next 5 years in order to justify its current trading price.

kors2

In the second table you will see that even forecasting a fairly pessimistic 3% sales growth over the next 5 years, which is less growth than in any of the previous 5 years, results in significant upside for KORS.

We can conclude that the “hurdle rate” for KORS to deliver enough sales growth to justify its current price and to deliver a solid return to its shareholders is extremely low and likely to be met or outpaced.

The ability to build fine-tuned models and implementing your own expectations to come to refined valuation conclusions for vast amounts of companies or to quickly screen down a pool of constituents to only spend time on companies with low expectations serves as a valuable tool for hundreds of money managers around the world.

When you compile the Implied Sales Growth expectations for all of the industrial companies in the S&P 500, we can then develop a “hurdle rate” for the entire index and communicate with clients the current expectations in the market and when the index approaches abnormal ranges signaling extreme under/overvaluation.

The chart below highlights current and historical implied sales growth expectations embedded in the market price for the S&P 500 index (Industrials) compared to the sales growth these stocks have delivered over the past five years. Currently within the S&P 500 we see that the median company in the index is priced to grow revenue by around 11% over the next 5 years, while the median company in this group has delivered just under 8% on average over the past 5 years signaling that current expectations are quite lofty. Although the Implied Sales Growth is still within normal range, it is slowly approaching the +1.5 StdDev threshold which would be a cause for some concern. Overall the index looks overvalued.

sp-implied-sales-growth-chart-jan-2017