*Paying too much for a stock – even a high-quality stock – significantly increases the risk of permanent capital loss. This is because there is no guarantee that the growth in value will be sufficient to compensate investors over the long term. To establish whether a share is overvalued, investors must therefore determine whether the market’s expected growth rate is realistic or not.*

*Paying too much for a stock – even a high-quality stock – significantly increases the risk of permanent capital loss. This is because there is no guarantee that the growth in value will be sufficient to compensate investors over the long term. To establish whether a share is overvalued, investors must therefore determine whether the market’s expected growth rate is realistic or not.*

**Paying too much for a stock increases the risk of permanent capital loss **

It is often said that it does not really matter what price you pay for a company if it’s a very high-quality company. This theory may appear to be true over the very long term, since the annual rate of return becomes less sensitive to the purchase price when spread over a very long period. However, even small differences in annualised rates of return matter because they compound over time. We have also recently seen several highly rated companies lose significant amounts of value.

Paying too much for a stock therefore increases the risk of permanent capital loss, and pushes up the opportunity cost considerably when you compare the stock to other investment opportunities. Clawing back losses on a stock while others are making money isn’t very rewarding.

**Price to earnings (PE) ratios provide useful insights into potential loss in value **

The PE ratio is probably the most widely used (and misused) valuation metric employed today. A PE ratio is a simple ratio that indicates how long it will take for the current earnings level of a company to equal the current price investors are expected to pay (in other words, the payback period in earnings, at the current level of profitability). It is, however, important to note that there are many underlying factors that play an important role in this equation.

By looking at a few examples, we illustrate why the potential loss in value for companies with high PE ratios can be so extreme.

**A simple equation shows that a company’s growth rate is a major factor in determining its value **

Academic literature teaches us that under normal market conditions, the value of a stock is a factor of the cash flow, growth rate and return on invested capital (ROIC). If we assume that earnings and cash flow are the same (which is obviously not always the case), we can determine the value of a stock at a certain level of earnings (cash flow), given an expected growth rate and an expected ROIC. If we divide that value by the current level of earnings, we get the company’s PE ratio. The value of the stock is directly correlated to the ROIC and the growth rate. The value will increase if the growth rate or the ROIC increases.

If we assume that the ROIC is constant over time, the value, and the PE ratio for that matter, is determined by the growth rate. A simple sensitivity table for fixed periods of growth can show us how the PE ratio will increase or decrease for different expected growth rates.

**Considering the growth rate that a PE ratio implies helps identify unrealistic growth rates **

These sensitivity tables are often used to determine what a ‘fair’ PE ratio should be for a company based on expected growth rates. We often switch this question around by asking: if the current PE ratio is ‘fair’, what is the implied expected growth rate? This is called ‘expectations investing’, where you determine what growth rate is implied by the current valuation. This approach is very useful to point out when valuations are implying unrealistic growth rates.

**Highly valued companies can lose significant value, despite high expectations **

Two highly rated companies that have recently lost significant value are Mediclinic and Mr Price. Both companies have reported disappointing earnings over the last few months of 2016. Figure 1 shows Mr Price’s share price and PE ratio.

The market tends to react brutally to earnings disappointments where long-term expectations were very high. In the case of Mr Price, the share price has gone from R240 to around R140 in less than four months, while Mediclinic has gone from R210 to R125 in five months. The PE ratio for these two companies have gone from 23x and 27x to 15x and 17x respectively. In both cases the loss in value from recent highs is just over 40%. With such a significant drop in value in such a short space of time, the question is: what is the ‘right’ price for these two stocks?

To determine whether the implied growth rates may have been unrealistic at the higher price levels, we considered the implied growth rates for each company for two distinct periods at both the higher share price levels and at the current (lower) price levels. The first period is a period of 10 years, during which time some companies can exhibit a clear competitive advantage and grow at a faster pace. The second period is from year 11 to infinity, when in most cases growth rates converge around an average.

**A closer look shows that growth expectations were unrealistic **

At a share price of R240 for Mr Price, the market was expecting the company to grow at 13.4% per year for the next 10 years (all other things being equal), while the expected growth rate at R140 is 8.5%. In the case of Mediclinic, the market was expecting growth of 18.4% per year for the next 10 years at a price of R210, while at a price of R125 the expected annual growth rate for the next 10 years is 13.7%.

If one considers a 13% growth rate in earnings per share for Mr Price to be unrealistic, paying R240 a few months ago was too high a price. It exposed investors to a significant risk of a permanent capital loss. Obviously, we cannot say with certainty what Mr Price’s growth rate will be over the next 10 years. The company may well grow at 13%. However, we do know that a growth rate of 8% is more likely. In other words, at a price of R140, investors will be rewarded if the growth rate turns out to be higher than the implied 8%. Based on these prospects, we have recently added Mr Price to our portfolios.

It’s important to note that we can never distil any investment case into one ratio or number, since there is always a range of assumptions and biases at play. However, these ratios can be very useful to get a feel for market expectations.

**Understanding growth expectations can help identify undervalued – and overvalued – shares **

The expected growth approach can point out where shares are significantly undervalued. About a year ago when Barloworld was trading at R62, the 10-year expected growth rate was a mere 2.2% per year. If we assume inflation is 6%, this means that the market was expecting Barloworld to deliver negative real growth of -3.8% per year for the next 10 years. At Barloworld’s recent share price of R115, this has increased to a much more realistic 10-year growth rate of 11%.

It is interesting to note that some high-quality companies for which the market has very low growth expectations could prove to be very good investment opportunities. An example is Woolworths – at a share price of R67, the implied growth rate for Woolworths is less than 9% per year for the next 10 years.

For Capitec (R670) and Clicks (R125) on the other hand, the implied 10-year growth rates are very high at 15% and 16% per year respectively (see Figure 2). Both have great track records, but 10 years is a long time. We suggest that buyers beware. In Figure 2 we can see how the implied growth rates for these two companies as well as for Barloworld changed over time. The huge opportunity provided by Barloworld in late 2015 is clear, while the implied growth for both Clicks and Capitec appear to be very high.

**Figure 1: Mr Price Group’s share price and price to earnings (PE) ratio (2007 – 2016)**

Source: FactSet

**Figure 2: Capitec Bank’s, Clicks’ and Barloworld’s 10-year implied growth rates (2007 – 2016)**

Sources: Company financials, Denker Capital