One of the things I have been reviewing lately is when you see a large share price decline without a commensurate decline in the expectations for a given firm. For instance, recently I detailed that McDonald's (NYSE:MCD) share price has declined by about 15% in the last five months, and yet, general earnings expectations are actually better than what they were.
Another security that fits this description is CVS Health (NYSE:CVS). In May 2016, shares were trading hands around $106. As I write this, the number is closer to $86 - a 19% drop in a rather short time period. And I'd argue that the expectations for the firm have not declined materially (and certainly not to the same degree as the share price).
Here's a look at the past three sets of estimates put out by Value Line on CVS:
You can see that expectations for the company have remained steady, with a slight (very slight) reduction in the intermediate-term anticipated earnings - certainly not to the degree of a nearly 20% reduction in the share price.
I'd chalk this price action up to a combination of two things: valuation, and the natural ebbs and flows of market pricing. At $106, shares of CVS were trading hands around 18 times expected earnings, as compared to a historical P/E average in the 15-18 range. So you were looking at a valuation on the upper end of normal to go along with the idea that all sorts of things can happen in the short term. There's no requirement that shares must trade at a given valuation.
Let's see how much of a difference this share price drop could make. The future growth expectations for the business remain quite robust. Using the above numbers, you're looking at 10-11% annual growth. And if you check in with other analysts, growth up to 15% per annum is anticipated. As described above, the average historical earnings multiple for the business has been in the 15-18 range. With these numbers in mind, we can come up with a range of scenarios over the next half-decade to get a feel for the current value proposition:
In the above table, I have outlined four basic scenarios: "Bull," "Base," Slow" and "Zero." Obviously, there are many more possibilities than this, but this gives a fairly wide range (0-10% growth and an ending P/E ratio from 12 to 18). In the above example, dividends are anticipated to grow in line with earnings, which could be a bit understated given the company's lower payout ratio.
You can see that based on today's price, should CVS grow by anything like it is expected (10-15%), the ongoing investor could stand to see solid to exceptional investment gains. Alternatively, should the company not perform up to expectations, the annualized returns appear rather lackluster. Whether or not the security is currently attractive depends on your viewpoint for future growth.
Here's a look at what the above assumptions could mean with a starting share price near $86, as compared to the previous price near $106:
A couple of things stick out for me. For one thing, you likely still need some growth to justify an investment in the business. If it's 10% or 15% growth, you're looking at exceptional return possibilities. Yet, if it comes in on the lower range, that's not necessarily the case. For some companies, 3% or 5% growth is fine (AT&T (NYSE:T) comes to mind), but for CVS, you already have a bit of an expectation baked in.
The second thing to note is that it's now easier to justify an investment thesis. Previously, with a share price of $106, if CVS grew by say 7% per year and traded at 15 times earnings, you'd be looking at 3.3% annual returns. Today, with a price closer to $86, those same assumptions mean you'd be looking at the potential for 7.7% annual returns.
Just to give you some context, a 3.3% yearly gain would turn a $10,000 starting investment into $11,800 after five years. A 7.7% annual return would turn that same $10,000 starting investment into $14,500. In other words, the difference over a five-year period could be magnitudes of return, and this is all based on a lower share price rather than changing business assumptions.
In my view, CVS is now more attractive today. You have a materially lower share price, but quite similar intermediate-term business expectations (not to mention the possibility for upbeat longer-term expectations). In turn, the "investment bar" is now lower as well. This does not mean an investment must work out, but it does allow for a more compelling security as compared to a few months ago.
Disclosure: I am/we are long MCD, T.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.