The stock market has a big problem. To understand it, look closely at earnings.
Few things matter like corporate profits. The growth thereof determines how much an investor is willing to pay for a particular stock.
In a period of rapidly rising profits, rapidly rising stock prices follow. The earnings path ahead is critical—even more so if the stock’s valuation is in premium territory.
To better understand this issue, let’s take a deep dive into the recent DSW (NYSE: DSW) earnings report.
Prior to releasing its operating report for the quarter ending July 31, 2015, DSW was, like most stocks, in a free fall, down some 10% in a short period of time.
The shoe warehouse giant’s pre-earnings valuation was on the high side. For the last few years, this company has been a stellar performer in the market, with earnings seemingly growing in perpetuity.
Unfortunately, economies do not grow in perpetuity. Eventually, there’s a contraction and business slows. It’s simply unrealistic to assume that a company can continue growing profits at a rapid clip.
Wall Street analysts studying DSW understand the profit growth issues facing the company. In advance of DSW’s earnings report, those analysts, on average, anticipate profit growth from the current fiscal year ending January 31, 2016 to the next to be less than double digits at 9%.
Slamming on the growth brakes had yet to be reflected in the stock.
Prior to the release, shares of DSW traded for nearly double its expected profit growth rate at 16 times current fiscal year estimated earnings. That valuation may be appropriate for a company growing profits in the 20% per annum range, but not single digits.
On the surface, DSW’s earnings report was as analysts expected. Profits met estimates, but sales fell short. More importantly, guidance for the current fiscal year was in line with expectations.
On a day the market opened sharply higher, DSW shares sunk. With momentum clearly gone from the stock, DSW was left to stand alone on the merits of its business and the current valuation.
Basically, there was only one direction this one was going: straight down. By the end of the selling, DSW lost more than 10% of its valuation.
What should be very troubling for market bulls is that despite that discount to DSW’s valuation, the stock remains expensive. All that selling did to the stock was lower the PE multiple to 14.5 times earnings. Clearly, that’s more attractive than where the number stood before earnings, but given the risks to the economy and already stagnating profit growth at DSW, there is more downside potential here.
Therein lies the problem for the market that is playing out for many stocks, not just DSW.
What is not reflected in DSW’s profit expectations is the damage done during a recession. At the moment, the risk of recession at some point in the next 6-18 months is rising by the day. That has to be factored into the valuation equation for DSW and other stocks, doesn’t it?
When looking for an explanation for the market sell-off, you can forget about China and the Federal Reserve. Instead, focus on valuation and the very real risk that the economy may contract in the near future.
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