April is the month when most listed companies publish reports for the first quarter of the year. Therefore it is often called a reporting season. The market has its expectations and forecasts, analysts-charmers publish their "divinations" about what the companies may present, and each individual investor sets his sights on something or creates alternatives for what they would do, depending on which scenario comes true. A company may present results in line with expectations, fail to meet expectations or exceed expectations. The market tends to react to each of these possibilities, but there is no guarantee that it will never overreact or underestimate a factor too much. It may be worthwhile to look for such overreactions in the market for lucrative investment opportunities.
Constructions on western stock exchanges
Since April 25 to April 27, Europe's largest indices, the DAX, FTSE100 and DE40, have fallen by rather small amounts (in the range of 0.5 to 2 percent). Similarly, the U.S. S&P 500 index has fallen by about 2 percent during this time. These are figures that seem inconspicuous and are unlikely to be of much significance in the long term for the indices as a whole. This is simply a certain correction that occurs in the markets on a fairly regular basis. However, it is possible to break these indexes down or go beyond them and try to look for companies whose discounts are more than negligible and whose quality is still high, i.e. higher than the new price would suggest. So let's delve into the subject of how this could be done.
Source: Tradingview
What does it mean to be cheap or expensive?
The price of a single share in absolute numbers doesn’t tell us much. What knowledge do we have from the fact that some shares cost, for example, 300 US dollars and others cost 40 pounds sterling? We are unable to deduce anything from this information. This is similar to total capitalization, except that it allows us to determine whether a company is rather large or rather small. A little more will tell us how the price changes over time, how much it cost in the near past, how much in the distant past, and how much it costs now. However, this is not enough. A true overview and information allowing to draw specific conclusions and make a reliable assessment may be provided by comparing two or more financial figures within a ratio, and then a comparison may be performed between companies (preferably operating in a similar industry). Using various indicators provide us with an insight into whether the evaluated company performs better or worse than its competitors, and whether it is expensive or cheap relative to the industry it operates in.
If we want to answer the question of whether a company is cheap or expensive and whether buying it at a given market price is a good bargain, we may pay attention to the price-to-earnings (P/E) and enterprise value-to-EBITDA (EV/EBITDA) ratios, where the former is quite popular and well-known. Its result is obtained by dividing the price by the profit earned. It shows how much we have to pay for a share of profits. The smaller the ratio, the cheaper the company’s share of profits is. Meanwhile the bigger the ratio, the more expensive it is. Its low level may therefore serve as a solid argument for buying the shares of the company.
The other ratio, EV/EBITDA, also works by the same principle but is generally less used. EV, or enterprise value, is the company's market capitalization plus liabilities, while EBITDA is not the final profit, but one before deducting payroll (I), income tax (T), and depreciation and amortization (DA). It shows the total cost to both - equity and debt providers - for the profits and cash flows of the company. A share buyer may think that using this ratio might blur the picture by mixing the perspective of a potential shareholder with that of a creditor. The opposite may be true - this ratio indirectly informs about the company's debt level, the health of its debt, and its cash flow. The nature of EV/EBITDA allows one to have a more comprehensive picture of the company’s finances and may be even more valuable than the P/E ratio in the case of some industries.
These types of indicators are called comparative as usually they are used to compare companies with each other. It is also worth noting that the potential lies in using them to compare the company itself in terms of historical data, and this is where the crux of the matter we are discussing today lies. If a company's stock price has fallen in earnings season because it has not lived up to market expectations, it is worth noting how the company's P/E and EV/EBITDA ratios have behaved. If they also fell, it means that the price of the stock fell more than it "should" have fallen due to the decline in current earnings. This is what makes a strong argument for the fact that we may have a chance to buy a good quality company at an affordable and bargain price. It can be said that when looking at a company, it is useful to compare it in different directions, both in time series(the same company at different times) and cross-sectional (a given company against others in the same industry).
Puma SE - a case study
A good example would be the German company Puma, which manufactures sports apparel, footwear, and accessories. The company announced that it is expecting to grow at a low to mid-single-digit rate in the second quarter, which is below its full-year target, citing high inventory levels and ongoing challenges in the market. The stock fell 2.7% as a result of this announcement on April 26.
Source: Tradingview
By looking at Puma’s P/E and EV/EBITDA ratios before April 25 and what they are now, we may evaluate whether or not we have found a potential investment opportunity. Similarly, using a cross-sectional comparison, which is a more classic way of applying comparative ratios and which also should not be underestimated, we may compare Puma with other companies operating in the same industry and see which one has a lower level of these ratios, i.e. which one is relatively cheaper. A good example here would be Adidas, which is also a German company and has the same business as Puma. Puma's P/E ratio is as much as several times lower than the level of this ratio for Adidas, so this allows us to conclude that Puma is relatively cheaper than Adidas.
To avoid misunderstandings, one important thing should be clarified. Data for only one quarter should not be used for these indicators. These are annual indicators and the quarterly results are only to serve as an update. Meaning that in case the quarterly earnings were used the ratios would come out suspiciously high and unsuitable for comparison. Instead, the numerator should be divided by the summed results of the last four quarters, because this is the equivalent of a year.
As a point of interest, it is worth mentioning that the level of ratios like P/E and EV/EBITDA and their change over time can be presented on an axial chart, just like the stock price itself. This opens the door to subjecting them to something like technical analysis. However, it would certainly not be appropriate to use the same evaluation criteria as for more traditional technical analysis, as such charts may reflect quite different things.
The index-comparison method is undoubtedly very valuable, but even here someone must be careful. The mere fact that a company is cheaper than another in a similar industry does not necessarily determine definitively that it will be a better investment. The more expensive company may have other elements of quality, which are not included in the given ratio, at a better level than the cheaper one (this illustrates a certain advantage of EV/EBITDA over P/E), and this may make the more expensive company worthwhile nonetheless. Some analysts and investors like to say that cheap companies are cheap for a reason, and in this respect their caveat makes sense. In this regard, it is also worth looking at the company's growth prospects as a business and the specific risks it faces. One might say not to compare a company only backward and sideways, but also - and perhaps especially - forward.
Paweł Szarmach, MPW, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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