The aim of this article is to present a method of identifying over- and under-valued stocks; in this case, stocks in the food processing industry, and then to discuss possible reasons for the misvaluation This involves making use of the wealth of basic statistics that are available on financial news sites to see how top analysts are rating their performance.
Why analyze stocks from only one industry? Economists tend to operate on the assumption of ceteris paribus - 'all other things equal' - when measuring and predicting variables. This assumes that some independent variables are held constant when making predictions about a dependent variable.
For stocks, earnings are determined by a whole range of independent variables, including management, financials and location. A major determinant, however, is the global market in which a sector must operate, which is determined by macroeconomic trends. The added value of analyzing the competitors in a single sector is that they all have a similar global market. The use of statistics for comparison is therefore more meaningful, and can highlight differences and over- and under-valued stocks.
In this case I am looking at the five largest multinationals which operate in the global market for food processing, to minimise any variation in fundamentals due to geographic differences.
|Market cap ($bn)|
Differences between the companies may still arise, for example in their products. In economics, we would assume that producers of normal goods, such as Danone, would suffer less during a recession than producers of more luxury goods, such as Kraft. On the other hand, Danone is less diverse and is subject to policy risk due to the reform of the common agricultural policy. In this case we shall assume that their markets operate in a similar way.
First up in the analysis are two measures that should theoretically tell us whether shares are over- or under-valued; the price-earnings-growth (P/E/G) ratio and risk-adjusted return.
The P/E/G ratio adjusts the P/E ratio for expected growth. It corrects the P/E ratio for the fact that low earnings may be due to investment which has yet to yield returns. The data here are taken from Reuters.
In theory all companies should have a P/E/G ratio of 1; any fairly valued company should equal its growth rate. Of course, the difficulty is making accurate estimates of growth. The data here are likely based on analysts' projections, taking into account past averages, but when markets are volatile, as they currently are, these projections are especially difficult to make.
All of the companies listed here appear to be heavily over-valued; especially Nestle. It is likely that they are adjusted for risk.
|Earnings yield (%)||Beta|
As we can see, all of the companies have a low market risk. Indeed, Danone has the lowest P/E/G ratio but the highest market risk. The following graph plots P/E/G against risk:
All of the companies seem to fall along a similar line, except Nestle, which appears to be over-valued even when adjusted for risk. General Mills and Danone fall furthest below the line. So what is the high P/E/G due to, the P/E ratio or growth forecasts?
|Market cap ($bn)||P/E||P/E(f)||ROE||ROI|
Nestle has the median ROE, which is just slightly below the mean. Its ROI is above the mean and the median. The P/E and forward P/E ratio are also above the mean. What analysts at Reuters seem to be saying is that, despite a healthy performance over the last 12 months, they expect Nestle's earnings to have lower growth than its competitors.
Nestle's share prices have gone down over the past year; the most out of the whole group. One would assume from a cursory glance that Nestle is more likely to be under-valued than over-valued. Neither price trends nor financial ratios explain Nestle's high P/E/G ratio. Nevertheless, top analysts are giving Nestle low growth forecasts. Nestle appears to be overpriced. If this is true, markets are either wrong about risk or future returns. Indulging in a little speculation, there are two possible explanations that I can think of for both of these.
One possible explanation, focusing on returns, is that Nestle's immense size means that the company cannot grow much more, hence low growth forecasts, since the only striking difference between Nestle and its competitors is its size. In this explanation, markets fail to recognise this fact but analysts do not. However, this is implausible; Nestle doesn't have a monopoly, nor is it incapable of diversifying.
A second possible explanation, focusing on risk, is that due to Nestle's size, people generally perceive it as lower-risk than its beta actually suggests. Although its current financials are sound, markets are generally correct about low growth forecasts but are prepared to tolerate them due to false perceptions of low risk.
Anyway, I hope you have enjoyed my little experiment in trying to make use of the wealth of information that is freely available through financial news sites, but whose assumptions are often left unexplained.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.