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Goodwill hunting

Stock market investing has been around for countless decades, as have various theories (efficient markets, behavioural finance, and others) about the character of equity markets and the purported key to outperformance. Regardless of the current trends and observations, one element of successful investing remains constant and is a unifying element across stock markets globally – determining the fundamental value of a company and its ability to generate earnings today and in the future.
A company generates wealth for its shareholders by deploying its assets to produce goods and/or services, which are sold to consumers at a profit. Its assets are typically financed by a combination of shares and debt; therefore, the accounting value of a shareholders’ stake is equal to the difference between assets and liabilities. This number is known as book-value, or book-value of equity.
From the shareholders’ perspective, the most relevant value is the per-share value, ie, book-value per share; this represents the accounting value of each share. As a company moves from one fiscal period to the next, the book value increases by an amount equal to earnings (also known as net income) minus dividends. Generally speaking, net income equals the difference between revenues and the cost of producing the goods and/or services, taking into account amortisation and depreciation charges, as well as taxes. Therefore, the basic measure of the wealth-creation capability is earnings.
The market price of a company represents the aggregate valuation (by the market) of its book-value, plus the present value of expected future residual earnings. The key component in the present value calculation is the cost of equity capital1, which is the return that investors require from investing in a specific company. Companies that are viewed as riskier will have a higher cost of equity capital. In other words, investors will invest in a company if the expected rewards are commensurate with the perceived risk. Residual earnings are earnings net of the risk-adjusted return on book-value; that is, the risk-adjusted wealth created by the book value.
Alternatively, the market value of a stock represents the markets’ valuation of its book value, plus the expected, incremental wealth to be derived from that book value over time. Therefore, the difference between market price and book-value-per-share, sometimes referred to as goodwill, represents the latter of the two components2.
If the difference between market price and book-value-per-share does not change significantly over a given fiscal period, then the difference between end-of-period and beginning-of-period market prices will be roughly equal to the corresponding difference in book-values. But, as mentioned above, the difference in book values is earnings minus dividends. Therefore, the difference in prices plus dividends will be roughly equal to earnings. Dividing through by beginning-of-period price, shows that the return on the stock over the holding period will be approximately equal to the earnings generated over the period divided by beginning-of-period price. The latter quantity is known as earnings yield3.
This is a fundamental result: a primary determinant of stock returns is earnings yield. This explains why active equity managers and sell-side analysts are so focused on forecasting earnings; and why the market reacts so strongly to earnings news. A manager with better-than-average insight will form more accurate forecasts of future earnings and invest in those companies that offer a potentially higher earnings yield. If the forecasts do turn out to be more accurate, the managers’ picks will be rewarded as the market adjusts prices to reflect delivered earnings. In other words, the astute manager will profit from positive earnings surprises, and will avoid negative earnings surprises4.
In practice, there can be substantial variations in goodwill from one period to the next. There are two important sources of variation: First, there is the process whereby the market adjusts prices for discrepancies in relative valuation. Companies that are similar - for example, companies in the same industry and with similar balance sheets - would be expected to generate comparable residual earnings in the future.
Moreover, the cost of equity capital for such companies should also be very similar. Therefore the market will adjust their prices so that both stocks exhibit similar relationships between prices and their corresponding book-values and earnings5. This adjustment process includes the earnings yield effect, plus the effect whereby discrepancies in the valuation of book-value are eliminated.

The second source of variation is more complex. As the economic environment in which companies operate evolves, their ability to generate earnings will also evolve. More precisely, as the economic environment evolves, equity market participants form a view of how earnings are likely to develop in the future; and accordingly adjust stock prices relative to their fundamentals.
For example, at the beginning of 2005, there were significant demand/supply imbalances in oil and the market bid up prices of oil stocks in anticipation of strong earnings in the course of 2005. Towards the end of the year, investors started to take profits in those companies, in spite of the fact that the imbalances remained essentially unchanged. The market view became that the strong earnings growth in 2005 would not continue into 2006.
Another interesting example is the behaviour of technology stocks during the second half of 1999. At that time, innovation was taking place at an unprecedented pace and all companies were motivated to upgrade to the most recent technology as the year 2000 approached.
Technology analysts concluded that the rate of earnings growth would continue into the foreseeable future. As a result, the cost of capital became very low (as the risk associated with investing in those companies was deemed to be low in relation to the expected reward).Given that view of growth, regardless of how implausible it seems today, market participants dramatically increased the price they were willing to pay for these companies thus increasing the multiples, albeit in an unrealistic fashion.
In all cases, the unifying theme is that company valuations and stock returns are inextricably linked to expectations about future earnings, whether it is short term, or earnings-growth expectations over the longer term.
Rigorous analysis of company fundamentals was first popularised in 1934 with the publication of Graham and Dodd’s seminal work, Security Analysis. Their emphasis on understanding the fundamental value of a company and its ability to generate earnings is as true and relevant today as it was nearly a century ago.

1. An important -related- concept is the equity risk premium, which is the difference between the cost of equity capital and the risk-free rate
2. A more common measure of the same relation is the PB (price to book) ratio.
3. If earnings are positive, earnings yield is the inverse of the PE (price to earnings) ratio.
4. A positive (negative) earnings surprise occurs when actual earnings are above (below) the consensus.
5. In simple terms, this means that prices will adjust so that their PB and PE ratios are very similar.
Augustin Sevilla is chief investment officer of AXA Rosenberg Investment Management in London

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