Growth and the curse of the high share price

There has been much market commentary about the impact of the FAANGs (Facebook [now of course Meta], Amazon, Apple, Netflix and Google) on the global equity markets.?In recent times, market commentators have also remarked about the potential impact of inflation on the cost of capital and the potential for this development to impact the value of the FAANGs.

The most startling development was the earnings release of Meta, which saw the social networking behemoth fall in one day by almost 33%. This was after indicating that for the first time that subscribers on its main site FaceBook fell across the quarter for the first time since the company's establishment.

For the casual observer, two questions emerge:

1.???????Has the cost of capital risen?

2.??????Is the Meta "crash" a harbinger of broader market changes?

The bottom line – the whilst base interest rates have risen, cost of capital hasn’t changed all that much (and stocks are inflation hedged for the most part).?And Meta’s travails aren’t anything new – they’re just the latest recipient of the curse of the high share price.

Read on for more details..

Has the cost of capital increased?

The cost of capital is a function of the time value of money and the price of risk.?The time value of money is proxied by the sovereign bonds which include (for high quality ones at least) the real interest rate and the expected inflation rate over the term of the bond.?In the Capital asset pricing model, the systemic risk of the market is captured by what is known as the Market Risk Premium (MRP), which is modified in the case of individual stocks by a Beta factor (a measure of correlation to the broader market).?

So all things being equal, if the MRP and real interest rates are constant, and inflation rises, this will lead to a higher headline cost of capital.

A German valuation firm computes a real time average cost of capital (for the US market), using a long dated bond rate, and an implied MRP.?The implied MRP back solves the MRP by using broker forecast cash flows, an assumed long term growth factor and by running them through a dividend discount model to compute the MRP implied by current market pricing.

The following is a snap-shot of their current calculations, which show that which interest rates have risen, their calculation of implied MRP has tightened with an overall stable cost of (equity) capital.?So probably no need to run for the equity market exits just yet (at least not for this reason, there are some troubling geopolitical issues that may cause you to do so, but that is a whole other story!).

Source: https://www.market-risk-premia.com/us.html, The author does not endorse outcomes of this model but acknowledges that it is consistently applied and provides a directional view over time.

But that is not the full story – Equity markets are inflation hedged investments, so even if interest rates rise for inflation, generally, the investment markets are resilient to that change.?Commercially this arises because of the ability for businesses to pass on inflation increases to customers, and mathematically it arises because in most DCFs terminal value growth rates equal inflation.

So in a inflation environment, you might be tempted into stocks rather than away from them! Naturally highly geared investments with borrowing covenants that might be tripped by higher headline interest charges (like some property perhaps), might be a plausible exception to this general rule, but perhaps not a reason for wholesale revisions to investment strategy and asset valuations.

So what happened with Meta?

On February 3 2022, Meta announced its annual results, including a drop in daily active users in some of its core platforms, and some data sharing and privacy issues (mainly in Europe).?The share price dropped from $323 to $237 (approximately 1/3).

The chart below, shows the impact on the trailing PE multiple of Meta on and around that date.

Source: https://ycharts.com/companies/FB/pe_ratio

Essentially, Meta went from a growth stock to a mature stock on that one day.?Or course, time will tell whether this view is locked in or a temporary aberration.

To me, this highlighted an issue for all companies with a high multiple (particularly when driven by high growth expectations).??Whilst having a high valuation is generally a good thing, it does create high expectations that management subsequently have to live up to.?If those expectations are not fulfilled, the share price reckoning can be severe.

This is the curse of a high share price.?This issue has existed for many years, and in fact when I first started in valuation, one colourful entrepreneur described it as being a market rooster one day and a feather duster the next!?Meta is just the latest company to have experienced the flip side of a historically high share price.

In order to illustrate the issue, I constructed a simple model of value driven by returns (proxied by ROCE), risk (proxied by WACC), and growth (proxied by inflation [see our first point above] and premium growth).

To illustrate the curse of the high share price, I then held everything constant, except for premium growth, and summarized the outcomes in the table below.?You can see to have the sort of day Meta had in early February, you just need to reduce your premium growth expectation by about a third; ouch!

Source: Author’s analysis

?Takeaways

The potential for higher interest rates driven by increasing inflation is clear.???The evidence suggests that, to date, offsetting factors have levelled headline costs of equity capital but of course, this could change.

However, thoughtful investors and valuers will recognize the inflation hedges exist in the commercial and valuation models that describe companies.?As a result, those same investors and valuers will not overstate the value impact of the return of inflation.

As for the FAANGs, they are blessed by high share prices, driven by growth expectations.?Meta’s recent experience revealed the curse of these high prices, in that management has to delivery on growth year after year, for fear of a dramatic valuation re-rating.

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Richard Stewart OAM is a Corporate Value Advisory partner with PwC. He has been with them for 35 years in Australia, Europe and the USA, doing his first valuation in 1992. He has helped his clients achieve great outcomes using his value skills in the context of major decisions, M&A, disputes and regulatory matters. His clients span both the globe and the industry spectrum. He holds a BEc, MBA, FCA, FCPA, SFFin, FAICD and is an accredited Business Valuation Specialist with CAANZ. He has written two books, Strategic Value, and Hitting Pay Dirt, and is an Adjunct Professor at UTS. The opinions in this article are his own and not necessarily PwC's.?