The Applied Finance Group's (AFG’s) ability to understand the embedded expectations in stock prices and what a company needs to deliver in revenue growth over the next 5 years in order to justify its current stock price helps investors to better understand whether a company’s expectations are rich or low. When expectations are low companies tend to be more likely to outperform those expectations and outperform their benchmarks. Applying this technique for an entire index is also a good way to tell if the index is over or undervalued as a whole.
By understanding the embedded expectations for growth that companies must deliver to justify their current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low.
Below is a chart displaying the implied sales growth (black dotted line) of the entire S&P 500 (INDEXSP:.INX) over the last 12 years as well as the 10 year median sales growth (red line) the index has achieved. This chart also illustrates the forecasted expectations (blue shaded area) for sales growth that the S&P 500 would need to generate in order to justify its current trading level according to the current embedded expectations.
Conclusion: When using the Value Expectations framework to solve for the implied sales growth for every company within the S&P 500 (assuming EBITDA and Asset Turns remain constant), we found that the average implied sales growth for the overall index is right around 13%. This is much greater than what the S&P 500 has been able to deliver over the last 10 years (10 year median sales growth for every S&P 500 company is 9.1%) which would suggest the index currently has high expectations.
The following chart displays the relationship between expectations (blue line) and the actual movements of the level of the S&P 500 (red line) over the last 12 years. The theory behind our analysis of embedded expectations and the trend that you can see in the chart below is that when expectations are high (red dots) the subsequent market performance tends to be negative and when expectations are low (blue dot) or reasonable it is much easier for the firm to meet or exceed those expectations and the market tends to follow with positive returns.
Conclusion: The current implied sales growth “priced-in” to the S&P 500 look rich relative to historic levels. Markets tend to experience declines in periods following when expectations are high.
In the final chart we wanted to help readers visualize how the markets have reacted in the past relative to their “priced-in” expectations. We measured the implied sales growth expectations in the beginning of each year (dark blue bar) and then measured the sales growth at the end of the year to see whether or not the index was able to meet or exceed those expectations. The final 3 bars (right side) show what the expectations for sales growth were in the beginning of 2010 (dark blue bar 9.45%) as well as what the street expected for sales growth in 2010 (grey bar 6.45%). The green bar indicates what the current expectations are for sales growth for the S&P 500 over the next 5 years to justify its current level which we mentioned in the first chart. What this illustrates is that in the beginning of 2010 expectations for sales growth were 9.45 percent which was somewhat high relative to historical levels and what the street expectations (6.45%) were to begin the year. Expectations have continued to rise this year with current expectations even loftier than they were to begin 2010.
Conclusion: As the market has rallied over the past few months, the expectations for sales growth have risen and currently look lofty relative to what the S&P 500 has delivered in sales growth historically. Now with such high expectations for the index and the difficulty of timing the unpredictability of the current market, it is increasingly important to focus on finding the best companies within the index using a consistent methodology and reliable framework in your stock selection process.
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