After better understanding our approach to evaluating the attractiveness of a company through AFG’s Economic Margin methodology, the content provided below is to help readers better understand how portfolio managers and analysts take a practical approach to applying these concepts.
Expectations analysis can be performed on a country, index, industry, sector, company, style, market cap or even on a custom set of companies such as a client portfolio. We will begin by addressing expectations analysis from a top down perspective. Secondly, we will address how to uncover parts of the market that are delivering high or low levels of expectations compared to what is priced into that segment of the market.
For example, below is a breakdown of each sector within the S&P500 showing the actual level of Economic Margin’s a typical company is delivering and the expected EM the market currently has priced in.
A quick observation identifies that Staples historically delivers roughly 14% EM’s while the market has an EM level of 23% priced in. We would suggest that investors pay close attention to their investment in the staples sector to avoid over priced stocks or potential torpedoes.
After assessing the sector, we can drill down to the industry level to determine which industries in each sector have high or low expectations.
Given the recent strong performance of Tobacco companies, it’s not a surprise that the industry has very high corporate performance expectations priced in. On the other hand, the big brick-mortar stores have relatively benign expectations priced in, relative to other peer industries in the Staples sector.
DIFFERENT TYPES OF EXPECTATIONS
There are three ways in which we help investment firms understand expectations, the sector and industry charts shown above evaluate expectations based on AFG’s proprietary corporate performance measurement Economic Margin (EM), and a more practical use can be to determine revenue and EBITDA margin expectations.
Each expectation measurement is equally insightful. If you are looking at growth oriented companies and want to better evaluate top line growth cadence, sales expectations might be the best perspective. Alternatively, if you are looking at margin sensitive companies that have steady streams of revenues, understanding the EBITDA margins priced into the companies might be most helpful.
Let’s examine expectations analysis from an individual company’s perspective to gain a better understanding of how a portfolio manager or analyst can apply this to their daily due diligence process on company research. The interface we will use to determine expectations is called Value Expectations.
As an example, let’s take a look at Intel (INTC) sales expectations. At the time of writing this article, INTC was trading at $34.25. By using its 5yr median EBITDA margin and asset turn, intel needs to deliver -3.91% sales growth to justify its trading price. This analysis suggests if we feel comfortable with Intel’s ability to deliver those margins and asset turns, the company has very low sales expectations priced into its stock, relative to what it has been able to deliver historically.
This is a single company example but a portfolio manager can apply similar analysis to review a client or prospective client’s portfolio, and quickly determine which companies might warrant a more thorough review. For example, if Estee Lauder (EL) were a holding, we could quickly identify that the company’s stock price has implied very high expectations. By using a realistic 5% revenue growth and solving for the EBITDA margin priced in, EL must deliver 22.75% EBIDA margin over the next five years to be fairly valued. In reality, EL’s highest level of EBITDA% was 20% achieved back in 2014.
Lastly, we will examine INTC based on their forecasted EMs vs what the market is pricing in. Below are the historical EMs of INTC, and forecasted EMs for 2016 and 2017. INTC is expected to deliver 4.46% EM in 2016 and 2017 while its current trading price is pricing EMs of just 2.74%. Given the company’s ability to consistently deliver EMs above 4% in the remote and recent history, we believe it is safe to say that INTC has low EM expectations priced in.
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