Why growth matters

Investing in shares with rising profit expectations is usually a much better strategy. Rising profitability is always a good sign. The reason why rising profits often translate into rising share prices is because of the tendency of investors to extrapolate recent trends into the future. What is good today is expected to stay good and vice versa.

The good news is that it is not too difficult to get a rough idea what share prices are telling you about the future. What an investor has to try and work out is whether the market's expectations are too low, about right or too high.

What share prices tell you

Have you ever taken the time to think about what a share price is? In very simple and practical terms, it is a price which is used to buy and sell shares as well as to give a value to your shareholding in a company.

However, share prices give the investor a very valuable piece of information. This is because a share price is theoretically the stock market's estimate of the value of all the company's future per share profits expressed in today's money.

If you understand this, you can understand why share prices move up and down and this can help you to become a better investor. Let me explain further.

Valuation 101

The theoretical value of a share is the present value of all its future profits or free cash flows. Professional investment analysts spend a lot of their time trying to forecast future profits. They then discount those profits using an interest rate (this is the annual return demanded by shareholders to compensate them for the risks of owning a share) to get a total value in today's money.

An example of how this is done is shown in the table below.

High growth company valuation

An analyst is valuing a company which is expected to grow its profits and cash flows strongly in the years ahead. To keep things simple, profits and cash flows are assumed to be identical.

The analyst prepares a forecast of cash flows for the next 10 years. Free cash flow per share is expected to be 10p next year and will grow to 23.8p after 10 years. After that cash flows are expected to grow by 2 per cent forever. It is assumed that investors want returns of 10 per cent per year to own the shares.

An interest rate of 10 per cent is then used to discount the cash flow forecasts to a value in today's money. So 10p per share in one year's time at an interest rate of 10 per cent is worth 9.09p today. This is because if you had 9.09p today and invested it at a rate of 10 per cent it would be worth 10p in one year's time.

The remaining nine years are also converted to present values. As the analyst does not have the time to forecast a company's cash flows for the rest of its life they need a shortcut at the end of year 10. This is known as the terminal value (TV). It is an estimate of what the shares will be worth in 10 years' time.

TV = (Year 10 cash flow x long-term growth rate)/(interest rate - growth rate)

Assuming a long-term growth rate of 2 per cent, gives a terminal value of 303.9p or 117.2p in today's money.

All the present value of cash flows and terminal value are added together to get a valuation for the share of 217.2p today.

Human beings are not very good at forecasting and so these forecasts should be taken with a pinch of salt. They will be wrong. As most investors don't have the time or inclination to do them either they tend to use valuation shortcuts instead. The most common shortcuts are multiples of profits such as price-to-earnings or PE ratios.

In our example above, the 217.2p valuation equates to a forecast PE ratio of 21.7 times (217.2p divided by 10p). The key lesson to take away here is that companies with high growth expectations have high PE ratios.

A company with no growth expectations will trade on a much lower PE ratio as shown in the table below.

No growth company valuation

In reality, there are only two main reasons why share prices change:

1. A change in the interest rate required by investors. This changes the present value of future cash flows. Higher interest rates lower them and lower rates increase them.

2. A change in future profit forecasts.

Given that interest rates generally change slowly, by far the biggest driver of share price changes is a change in the stock market's view of expected future profits. When these alter, share prices can move dramatically. This is what happens when a company announces that profits will be much higher or lower than previously expected.

Let's see how this works out in practice by returning to our high-growth company from earlier. Cash flow or profits per share were expected to be 10p next year, but the company now issues a profit warning and says that they will be closer to 8p. To make things worse, it believes that it will be at least another couple of years before profits can start growing again.

Analysts then slash their profit forecasts. They were previously expecting 13.8p in three years' time but now only expect 8p. This also forces them to radically reduce their long-term growth prospects of the business as well. The share price collapses from 217p to 112p. The PE ratio falls from 21.7 to 14 to reflect the lower growth expectations.

The impact of a profit warning

Why this is important

The key message that I want to get across here is that when you are investing in shares, expectations of profit growth are all important. It is very difficult to make money owning shares where profits are falling and are expected to keep on doing so.

You are effectively trying to swim against the tide and it is the tide that usually prevails. You need to swim with the tide and that means buying shares at a reasonable valuation where profits are expected to grow. This is why buying shares in a company after a profits warning can often be a mistake as things often continue to get worse before they get better.

However, what is even more relevant in today's stock markets is the danger of buying and owning shares with high valuations. These shares have expectations of strong future profits growth baked into their share prices. If the company behind the shares cannot meet those expectations then it is possible to experience some very painful losses.

We can see how important expectations of growth are by looking at some case studies of recent share price performances.

Domino's Pizza (DOM) has proven to be an excellent long-term investment. The company has been able to deliver strong rates of underlying sales growth (like-for-like sales) and complemented this with opening up lots of new stores and entering new markets. In doing this, it has generated high returns on capital employed (ROCE) and generated a lot of free cash flow.

Put simply, there has been a lot to like and it has not been too surprising that the shares have traded at a very high multiple of earnings. Last week, the company announced a solid set of results for 2016 but said that like-for-like sales had slowed from 11.7 per cent in 2015 to 7.5 per cent. It then went on to say that like-for-like sales had grown by just 1.7 per cent during the first nine weeks of 2017.

This sharp slowdown in growth has seen the shares lose 16 per cent of their value in a week. The real fear now is that trading continues to deteriorate and that like-for-like sales could turn negative. This could be bad news as Domino's Pizza's shares at 331p still trade on a trailing PE of 25.7 times and a forward PE of 21.9 times and look highly vulnerable to a downwards revision in profit forecasts.

If you want an example of how share prices and valuations can change rapidly in response to a deterioration in trading then Restaurant Group (LSE:RTN) is a classic case study. The group went through a growth phase which saw the valuation of its shares climb to more than 20 times earnings. When the group's trading began to deteriorate at the end of 2015 and profit expectations fell sharply, the share price collapsed.

Shareholders suffered a double whammy of lower profit forecasts with a lower PE multiple attached to them. This phenomenon is known as multiple compression and it can be deadly for investors.

Will this happen with Domino's Pizza shares? I've no idea, but the risk is there.

Fenner - low valuation with increasing profits growth

This process does work in reverse and is known as multiple expansion. It can be a good way to make lots of money from owning shares.

Manufacturing companies with lots of operational gearing (where profits change faster than the change in sales) can see long periods of forecast upgrades and downgrades as business conditions improve or worsen. Investors who ride an upgrade cycle can make a lot of money. Fenner (LSE:FENR) sells its conveyor belts and high-quality seals into cyclical industries such as mining and oil. This means that its profits tend to move up and down a lot over time.

The company has been through some tough times as mining companies cut back on their orders for its products. This saw its share price and valuation fall. At the start of 2016, its shares were trading on a rolling PE of around 10 times, indicating that investors were not too bullish about its prospects. Shortly after, trading began to improve. Higher profit forecasts had a higher valuation attached to them which led to the shares more than doubling in value over the next year.

Lessons for investors

A company's growth rate and expectations of future growth are all important. Investors can make money by buying lowly-valued shares - where expectations of growth are low - that have seen an upturn in trading. They can lose money by buying and owning expensive shares when growth starts to slow or decline. It can therefore be very useful to learn what the valuation of shares is telling you about future growth.

One of the most difficult things to work out is when to sell a share that has been growing rapidly. Unless you are really fortunate, you are unlikely to get out at the top. However, you could set yourself some rules which might allow you to walk away with a profit:

■ Set a maximum valuation for buying and selling shares. For example, a PE ratio of more than 20 is telling you that future expectations are high. Buying shares for more than this valuation might be risky. Selling at a PE ratio of 25 might not maximise your profit but could get you out before things turn sour.

■ Compare the PE with the growth rate in profits. This is commonly known as a price-earnings growth or PEG ratio. Shares with PEs less than the earnings growth rate can be cheap. Once the PEG ratio gets above 1.5 or 2.0, most shares are starting to get expensive. This is when it might be wise to take some money off the table.

Phil Oakley is a stock analyst for Ionic Information, maker of SharePad and ShareScope investment software. Read more from Phil, including his excellent Step-by-Step Guide to Investment Analysis at www.sharepad.co.uk/philoakley.

SPECIAL OFFER: Ionic is offering a three-month subscription to SharePad for just £25. www.sharepad.co.uk