Understanding the embedded expectations in stock prices, or what a company needs to deliver in revenue growth over the next five 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 will analyze the embedded expectations in the S&P 500 to see if they are high or low relative to the growth the index has achieved historically.
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 five years. The data is then aggregated to determine the average "hurdle rate" for the index.
At present, the S&P 500 index appears to be fairly valued. Current prices suggest that the market expects sales growth of 7.9% over the next five years. This compares to the 5-year historical median sales growth of 7.3%. While the embedded expectations are reasonable given what the index has achieved in recent years, do not expect to find stocks at bargain-basement prices.
In the chart below, the black dotted line represents implied sales growth of the entire S&P 500 over the last decade, while the red line represents the five year median sales growth the index has achieved. The blue shaded area shows the implied sales growth expectations that the S&P 500 would need to generate in order to justify its current trading level. This illustrates what the average company in the S&P needs to deliver in sales growth over the next five years in order to justify its current trading levels using five year median Ebitda margins and asset turns.
(Click to enlarge)