How market expectations can move stock prices

One of the hardest lessons to learn in the market is that it’s about expectations rather than reality. Even a great set of results can actually see a stock trading lower if those results were below expectations. Inversely, a poor set of results could see a stock trading higher if they weren’t as bad as the market was expecting.

The important part of this equation is knowing what the market as a whole is expecting. Some online brokers offer access to analyst consensus forecasts and this certainly guides us as to what is expected from results. Often the easiest way to gauge things is to simply watch a share’s price movement in the minutes and hours after an announcement regarding the company is made – whether it be a trading update, merger, board changes etc.

But there is a better way to manage this process. And in light of a number of recent sell-offs of stocks that did not meet market expectations, I thought it important to cover the price/earnings-to-growth (PEG) ratio again.

The first part of PEG is the price-to-earnings ratio (P/E). This is simply headline earnings per share (HEPS) divided into the share price. A 2 000c share with HEPS of 100c would have a P/E of 20 times. This tells us that assuming no growth going forward, it will take 20 years of profits to pay off the share price at the time. Now, of course we expect growth over that period and that’s where the G of PEG comes in: growth. So, PEG is then P/E growth.

To determine PEG, divide P/E by the growth in HEPS. For the above example, if the company is growing HEPS at 10% a year, that would equal a PEG of two times (P/E of 20 divided by 10% growth in HEPS). If growth was 30% a year, then PEG is 0.66.

In an ideal world, a PEG below one is attractive as a growth investment, while PEG above one is moving into expensive territory. In other words: HEPS growing at a higher level than P/E is good; if it’s growing at a lower level, it’s bad.

The trick here is to understand what growth it is you’re looking at. It’s all good and well to use the previous year’s numbers (which will be available in the company’s results), but this is backward-looking. You want to try and use a forward P/E.

A forward P/E uses the current share price and the expected HEPS for the year ahead. Now, knowing the future is impossible, but you can get a fairly decent idea by running your own numbers or using the consensus forecasts I mentioned above.

You can also front run it by looking at peers in the industry and seeing how they’re doing. If everybody else in the industry is seeing low, single-digit HEPS, then a reasonable expectation is that the stock you’re looking at will have the same sort of growth. Ideally, you’re investing in the better-quality stocks and are expecting better growth – so you may need to adjust your growth expectation slightly upwards.

So far this year, especially in the retail stocks, P/E values have been stretching from around 20 times to as high as 30 times – yet growth has been coming in flat or even negative, with a few exceptions. This has seen hard selling as profits are missing expected targets by a long way.

What we’re also seeing is very aggressive selling; stocks falling well in excess of 10% on the back of bad news, which is a relatively new experience locally. I suspect this is in part due to lower liquidity on our market and an Americanisation of our market. In the US, missing or beating by a cent can send stocks flying or tumbling, and we’re now starting to see that locally.

This article originally appeared in the 21 February edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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