Wednesday, February 25, 2009

The Dual and Compounding Effect of EPS

I've repeatedly mentioned EPS and PE as a model for creating a price for stocks. However, I've also cautioned against using it recently as there are some problems with it in this economy. To further understand how a model like this can fail (or rather, underestimate the effect of EPS on price), I thought it might be prudent to delve further into how EPS movement affects stock price.

Although the formula for price with regards to EPS and PE is quite simple (Stock Price = Earnings Per Share x Relevant Price to Earnings Ratio), it is in determining the appropriate ratio which is particularly difficult.

For instance, I had a previous target of RIM between $57.75 to $64.80 (which has gotten blown away with the recent plummet in stock price). RIM's quarterly EPS guidance was dropped to about the low 80's cents per share mark versus the high of 95ish. This affects RIM's stock price doubly because: EPS now shrinks rather than grows and the PE ratio also shrinks to match the corresponding lack of EPS growth. Especially for a growing company like RIM, investors get spooked when they think that the company won't exhibit the behaviour of a growing company and begin to behave more like a company reaching maturity in its industry - the reaction to their news that they have more subscribers but lower margins could be read as an indicator of that - further compounding the price drop in the "panic" category of selling (technically outside the scope of this post).

So with downwardly revised EPS guidance, the new annual EPS calculation as well as the relevant PE ratio used for PE analysis drops. Since the company doesn't look like it's growing any more, people struggle to find an appropriate PE ratio to assign to the stock. As I mentioned before, a mature company has a PE usually between about 8 to 12. A growing company will usually have ratios between 15 to 20.

[Aside: And I don't think RIM should be trading as if it's some sort of "speculative" tech stock. It's long past those days, yet the volatility just shows that there is some volume in there that is "emotional" (which I believe was confirmed by it's recent recovery and uptick - but again I digress).]

But just as with the PE or PEG ratio, if you aren't (or don't seem to be) experiencing growth, your potential outlook (beyond your current reported numbers) dims also, and your price takes that second hit.

However, having said that, any sign of strength will cause a compounded recovery in price by the same mechanics and this is a leading cause in the volatility of stock prices, especially those with volatile EPS.

Does all of this sound familiar? That's because it's essentially a very similar concept to the Capital Asset Pricing Model (CAPM) and the idea of beta, how the stock price moves with the market (but with more amplified effects). For growing companies who exhibit greater volatility, you can expect that their beta will also be quite high. The idea that with incremental risk come incremental rewards.

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