The Double "Whammy" of Lower Profits and Lower Valuations

One cannot help but notice that in the current bearish climate, many companies with once sparkling results and bright futures would have their growth rudely interrupted by the arrival of high oil prices, runaway inflation and a slowdown in economic growth. Many companies which were once touted as "sure-fire" growth stories had their businesses marketed by analysts (who of course wrote equally sparkling reports) and their target prices continually raised in the raging bull market which all but ended late 2007.

Now, one also cannot help but notice that the target prices and valuations of such companies are being slashed and reduced by a margin as deep as 50-60%, with some cases even up to 70-80%. This is what I would term as the "double whammy" of lower profits and lower valuation. Together, they form a deadly cocktail mix which can cause a once high-flying company's share price to come crashing back to Earth. Ok, some may argue that it was not justifiable to trade at such valuations in the first place, but bull market baloney is common and pervasive during the final stages of any bull market; thus investors and punters will simply ignore good advice and continue playing the Greater Fool Game (to their eventual detriment).

Basically, the premise is simple: a company reports a fall in profits due to rising costs and inability to raise prices sufficiently to offset these costs. To add to their woes, staff and admin costs have also increased and put a further strain on net profits. This would of course lead to lower profits in subsequent quarters and the company may see its net profit contract by about 40-50%. The problem is that when this happens, the growth multiple assigned to a company (called the valuation metric or Price-Earnings Ratio - PER) will also correspondingly fall because of lower expectations for growth. This can be clearly seen in the cases of some China companies which had been trading at valuations of 20-25x during the bull market. In today's bear market, with falling profits and limited prospects for growth in market share and margins, analysts are valuing it at a measly 5-6x PER. Thus, the effect of these 2 events causes a severe share price devaluation due to anticipated lower profits as well as putting a screeching halt to growth expectations.

This scenario is best illustrated with an example (as shown below):-

In the simple example, Company ABC reports a 20% drop in revenues for 2008 compared to 2007. As a result of increased COGS (same COGS with lower revenues - probably due to high oil prices), they report a lower gross profit of 33%. Expenses actually increased marginally by 20% in this example but the impact is that net profit is reduced by 60% (due to the lower absolute gross profit figure). Net profit margin is slashed from 40% to just 20% as a result of rising costs. Assuming the same share capital base from 2007 to 2008, EPS is also reduced by 60%. However, the important part of this example is the valuation given to the company. For 2007 (when growth was still optimistic and everything looked rosy), the company was accorded a PER fof 20x, thus valuing it at S$1.60. When the problems kicked in and growth was shown to be stunted, the valuation accorded is reduced to a mere 5x, which values the company at just S$0.16, representing a 90% drop !

Although this example may seem rather extreme, the point I am making here is that the numbers could very well represent that of an actual company (many companies see profit drops of about 40-50% in the current economic climate); but the impact to share price would be far greater than just 40-50% and could be in the magnitude of 70-80% (as illustrated) due to lower valuations accorded. Thus, it is no surprise to see a company which once traded at S$2.52 (its peak) suddenly trading at a mere S$0.43, for a drop of about 86%. The effect can be adequately explained by the example above, though of course I am merely using hypothetical numbers.

Therefore, it is crucial for an investor to use a lower valuation metric when seeking margin of safety, and to assume that growth slows down or smoothes out over a period of time, in order to avoid such a situation. When one purchases a company with the assumption of an annual 100% growth in net profits and a valuation of 20x, one is either being unrealistic or downright foolish because a company cannot sustain such growth at such high valuations for an extended period of time.