Value compression, sometimes called “multiple compression,” is simply when a stock’s valuation multiple, usually the price/earnings ratio, gets smaller. While straightforward enough to identify, understanding what is behind the compression can help you understand how investors’ perceptions are changing. To do this, let’s split the P/E multiple into its two parts, Price and Earnings.
One type of value compression occurs when the stock price remains flat but the earnings continue to grow. This can mean that investors like the company but don’t like the valuation. Over time, these two trends will compress the P/E multiple. In a classic example, Wal-Mart (NYSE: WMT) underwent this type of value compression over an 11-year period, from 2001-2011. The earnings (and outlook) remained healthy in 2001, but the stock was overvalued at the Price/Earnings multiple of 36 times (or 36x). It was said at the time that Wal-Mart needed to “grow into its valuation.” While the stock traded narrowly during this period, between about $45 and $55, earnings continued to grow steadily from $1.40/share in 2001 to $4.54/share in 2012. This compressed the forward price/earnings multiple to 11x in 2011. Investors perceived (correctly) that Wal-Mart’s earnings growth outlook was healthy, but they were unwilling to pay a higher share price for that growth.
For turnaround investors, this type of stock can be a real challenge but rewarding if done patiently. Buy too early because it is “cheaper than it was,” and you may have little to show for your investment for a long time. But waiting for a meaningfully depressed valuation combined with a significant positive change (new strategy or new management, for example) and some tailwind from a rising stock market can greatly improve your outcome. Wal-Mart had some help from both — so its shares have surged 60% and now trade at a forward P/E multiple of 18x.
With the market moving steadily higher over the past few years, this kind of value compression is increasingly rare, and its opposite (value expansion) is very common. However, at some point, when the market’s upward move stalls, we’ll see more healthy and steady companies needing to “grow into their valuation.”
Another type of value compression happens much more quickly — usually when a company falls out of favor with investors. The earnings may decline, but the collapse in the share price pushes the P/E multiple lower. A current example is AutoZone (NYSE: AZO), which traded at $800 last December but has declined 38% to around $500. However, its 2017 estimated earnings fell only about 4%, to $44/share, so its P/E multiple compressed from 17.4x to a current 11.4x. What changed: Recently weak results have investors worried that competition from Amazon (NASDAQ:AMZN), Wal-Mart and others might permanently weaken AutoZone’s revenue growth outlook.
Lower P/E multiples, like that of AutoZone’s, clearly appeal to turnaround investors, but require some catalysts or evidence that the earnings won’t turn downwards (producing a “value trap”).
LPL Financial (Nasdaq: LPLA) provides an example of another kind of value compression: temporary earnings weakness incorrectly extrapolated by investors. In December 2015, the shares traded at $45, with expected 2016 earnings of about $2.60/share, producing a P/E multiple of 17.3x. The company reported a very weak quarter just a few months later, driving the share price down by 56% to about $20. Earnings estimates for 2016 were cut by about 37%, to $1.65/share. The impact on the P/E multiple: it shrank to 12.1x. Investors believed that changes to the Department of Labor’s fiduciary standards, along with weaker advisor revenues and a secular move away from brokers, would permanently impair LPL’s earnings.
The opportunity in LPL Financial came from an overly compressed valuation, even on lower earnings estimates, as investors abandoned its shares. In this case, several improvements, including a new CEO, better expense control and higher revenues, along with some support from a higher stock market, led to restored confidence (indicated by a higher multiple) and restored fundamentals (indicated by stronger earnings), and thus a much higher share price. LPL Financial’s shares now trade at $45 again, up 125% from their $20 lows, with earnings estimates back at $2.60. The P/E multiple has recovered to 17.3x.
By separating the P/E multiple into its two components, Price and Earnings, a turnaround investor can greatly improve their understanding of the market’s perception of a candidate stock and similarly improve their turnaround stock selection.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.