The Applied Finance Group's (AFG's) ability to understand the embedded expectations in stock prices, or what a company needs to deliver in revenue growth over the next 3 years in order to justify current stock prices, helps investors better understand whether a company’s valuations are rich or low. By understanding a company’s embedded expectations clients can develop a “hurdle rate” to quickly determine if a company’s expectations are realistic. When expectations are low, companies tend to be more likely to outperform their benchmarks.
Applying this technique for an entire index is a good way to tell if the index is overvalued or undervalued as a whole. In this article, we analyzed the expectations for 400 of the largest (by market capitalization) industrial service companies traded in the US (excluding Materials, Financials, Energy and Utility companies). We developed a hurdle rate for each company to understand which companies have high expectations that will be difficult to meet or exceed, as well as companies with reasonable and low expectations for revenue growth relative to what they have delivered over the past three years.
The data is then aggregated to determine the average “hurdle rate” for the index. Our conclusion is that the expectations built into this list of 400 stocks are rather high. In the last three years, these companies delivered a median annual sales growth of 7%. Based on current trading prices, these companies need to deliver on average annual sales growth of 12% in the next three years to justify their market valuation, which is likely to be a difficult task given recent historical sales growth rates.
Below is a table displaying the implied sales growth of the 40 largest (market cap) industrial service companies over the last 3 years, as well as the median sales growth the index has achieved over that same period. We have then labeled each company as having Low, High or Reasonable expectations based on what they have delivered in sales growth historically relative to what is currently “priced in” to their current trading price.
click to enlarge