Better sales growth, lower stock price!

B. Venkatesh

Anup Menon

THE Business Line analysis showed that the five-factor model explained 77 per cent of the variation in tech stock prices. But how was the market using these variables?

We analysed the signs (positive or negative) associated with the estimated co-efficient. For instance, we tried to see if an increase in sales leads to a higher stock price.

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We found that sales growth and net profit growth have a negative relationship with stock price. On the other hand, we found that operating profit growth; absolute EPS and market cap have a positive relationship.

A negative relation between sales growth and stock price means that an increase in sales growth leads to a fall in stock price! Illogical as it sounds, this can be explained intuitively. The market normally expects a company to report a certain growth rate in revenue. What if the company falls short of the consensus estimate? The disappointment of the company not achieving the expected growth rate is a strong enough reason to send the stock into a downdraft. The same logic may hold for the market ignoring net profits as well.

Think the logic is twisted? Consider what happened to Infosys when the company declared a third quarter sales growth of 136 per cent. The market greeted the announcement by beating the stock down 7 per cent. The intuitive argument holds water because of the increasing number of analysts publishing research reports with their respective estimated growth rates.

The question then arises: If the market is ignoring net profit growth, why is it considering the absolute EPS to be valuable price-sensitive information? After all, EPS is but a function of the net profit (growth).

We attribute this to a behavioural phenomenon. An investor is, perhaps, comfortable relating per share earnings to the stock price rather than the net profit (growth). This way, he/she can gauge the proportion of the company's earnings that is attributable to her stock holdings. That, perhaps, explains why the EPS does not have a negative co-efficient as net profits.

But how can the positive relationship between EPS and stock price be explained? Well, the explanation is based on the assumption that the retail investors consider the stock price to be correctly valued. So, what happens when a company reports a higher EPS? At that moment, the PEM will come down as the EPS increases. A lower PEM prompts the retail investors to buy the stock concerned, pushing up the price. This could be why EPS has a positive relation to the stock price.

What about operating profit growth? Why would the market consider this variable important? We know that the net cash flow of tech companies is very volatile because they are mostly dependent on project revenue. This means a company that has reported a Rs 500-crore revenue this quarter may not necessarily report a similar or better performance the next.

Given this uncertainty, growth in operating profits is likely to be viewed as a positive factor. This is because operating profit growth reflects the company's ability to penetrate the market and command a high price for its services. It also reflects the company's ability to control costs to generate revenue.

But why is operating profit growth preferred to sales growth? The reason could be that operating profit growth is a clear indicator that the company is not undercutting to bag a contract. Viewed in this sense, sales growth may actually be a misleading indicator or need to be viewed in conjunction with operating profit growth.

Finally, market capitalisation also showed a positive relationship with stock price. We attribute this to the liquidity factor. The market typically prefers highly liquid stock. By liquidity, we mean the ease with which the investor is able to buy or sell a stock in the market without largely impacting the prices.