As the effects of the global pandemic continue to play out, business owners and investors alike are scrambling to assess the economic fallout and plan for an uncertain future.
Despite the shock reverberating through the global economy, equity prices have maintained their upward trajectory. What explains this disconnect? For insight on this and other questions, BDO’s Valuation & Business Analytics (VBA) team put real data behind the narrative and launched a new quarterly study that examines how industry and analyst estimates are evolving amid the COVID-19 pandemic.
In the June 2020 inaugural issue, “The Path Ahead, Analysis of Analyst Estimates for Insights on the Economic Recovery,” the BDO team looked at more than 20,000 equity analyst estimates for 428 public companies spread across 24 industries. Leveraging data algorithms and dashboard analytics, estimates were synthesized by sector.
While short-term COVID-19 impacts are well appreciated, opinions diverge on their duration and the shape of an eventual recovery. Many anticipate a U-shaped upswing. Given rising equity prices, that may make sense. But the aggregate data suggest a steeper and longer degradation in revenues and profits.
The analysis revealed stark sector differences in near-term effects and the timing and depth of a recovery. Although declines in expected revenues and profits for specific industries are no surprise, their magnitude and long-term ramifications, as conveyed by analyst estimates, are severe. The tables below, based on data from S&P Global’s Capital IQ database, display both near-term and long-term changes in estimated revenue and EBIT by sector.
Despite the near universal decline in forecasted fundamentals, equity markets have gone in a different direction. The chart below illustrates the change in aggregate total enterprise value (TEV) for each industry from 31 January 2020 to 31 May 2020, using market capitalization for the banking sector.
What was the correlation between market equity prices and the post-COVID-19 analyst revision? Using analyst estimates and changes in market values, the team explored this first on a relative basis for each industry and then based on the movements during April and May. The results highlight the broad disjunction between fundamentals and market prices on an absolute basis.
Relative Market Performance
In the study, the team analyzed the correlations on a relative basis for each industry by plotting their relative TEV change against relative changes in both 2020 EBIT and long-term EBIT. Plots above the line represent industries where the TEV performance was better than the relative decrease in corresponding EBIT: Market value performed better than analyst estimates would suggest compared to other sectors.
Plots below the line, on the other hand, indicate industries where TEV performance was worse than the relative decrease in corresponding EBIT. Market value performed worse than analyst estimates anticipated. Plots close to or on the trend line had TEV performance consistent with the relative movement in corresponding EBIT. Relative to other industries, market value performed as expected based on changes to estimates.
For many industries, both the near-term and long-term estimates look consistent and strongly correlate with the TEV performance. Other sectors, however, display a significant variation between changes in estimates and market values.
Relative Market Underperformers
The airline industry represents the largest negative outlier. Market values have plummeted as long-term EBIT estimates have held steady. While 2020 will be a tough year for the sector, post-COVID-19 estimates as of 31 May show a V-shaped earnings recovery.
Airlines have been pounded in the short-term, but the pandemic’s long-term effect is not expected to be as severe as in other sectors. Yet the relative TEV performance of airlines is consistent with the changes in 2020 EBIT estimates. That indicates investors are more focused on the near-term. As demonstrated below, revenue estimates are lower through 2023. So the expected recovery in EBIT is due to EBIT margin expansion: From 31 January to 31 May, the median expected EBIT margin for 2023 increased by 2.4%.
The “Trend Analysis” graphs include the aggregate EBIT estimate for sector companies at the end of each month from 31 January to 31 May. The estimates extend out for each future period in which meaningful data is available. The aggregate estimates for each year (and at each point in time) are common sized to the actual aggregate 2019 result. For example, a 2020 estimate of 110% indicates 10% expected industry growth, while a 90% estimate indicates a 10% expected decline. These graphs show a time lapse of the movement in estimates and indicate how both the near-term impact as well as the path toward recovery have changed since the onset of the economic crisis.
Insurance stands out as another market underperformer. Relatively minor long-term EBIT estimate declines imply significantly better relative TEV performance. Overall, as the following graphs indicate, the industry estimates have plunged, although the EBIT trend rebounded from 31 March to 30 April. The question is why and how might the firms in the sector diverge.
As of 30 April 2020, earnings estimates for property and casualty insurance companies like Allstate and Progressive were revised higher, presumably in anticipation of a prolonged US lockdown. The fewer miles policy holders drive, the fewer their related claims.
Relative Market Overperformers
Compared to earnings estimates in other sectors, market values in the retail — discretionary and luxury have not fallen as much. The impact, as depicted in the following graphs, is driven by an expected pause in demand and a parallel shift in the revenue curve from pre- to post-COVID-19 estimates.
The drop in revenue is also accompanied by a forecasted longer-term decrease in margin. The long-term EBIT estimates show a prolonged decline. Despite some of the most severe reductions to near-term and long-term EBIT estimates, market values have performed comparatively well.
The online retail and medical device sectors have outperformed expectations based on the downward revisions from pre- to post-COVID-19 2020 EBIT estimates, but their market performance aligns with long-term EBIT estimates. Investors are looking past the near-term drop in profitability and focusing on the sectors’ long-term prospects.
Absolute Market Performance
As analyst estimates continued to deteriorate from 31 March through 31 May, stock prices often moved in the opposite direction. The following table displays the percent decrease in 2020 and long-term EBIT from 31 March to 31 May, along with the percent change in aggregate enterprise value over the same period.
The Path Ahead
Despite the apparent disconnect, trends in May suggest that the precipitous decline in estimates may have hit bottom. While nearly all industries reduced their forward estimates in March and April, in May, the trend looked to be slowing and even reversing in some cases. For example, there was little change in both near-term and long-term revenue and EBIT estimates from 30 April to 31 May in 11 of the 24 industries. Estimates in four industries even recovered somewhat over that same period.
The magnitude and rate of downward revisions in May offer some hope that COVID-19 considerations have been fully incorporated into forward estimates.
In BDO’s next quarterly study, data will be analyzed through 31 August and the BDO team will explore whether analyst estimates will catch up with market values, or if fundamentals and market value will remain disconnected.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Eloy-CM
Kevin Prall, CFA, is a director with BDO USA, where he leads the development and implementation of technology enabled solutions for BDO’s Valuation & Business Analytics practice. His specialties include business enterprise valuations, intangible asset valuations, and forecasting for financial reporting, tax, and transaction support.
Prall is currently serving as the Business Valuation Standards Director at the International Valuation Standards Council (IVSC). In his role at the IVSC, he works with global leaders of the valuation industry, securities regulators, and accounting standard setters to advance the interests of investors and the capital markets. With the IVSC, Prall has authored a three-part article series on financial reporting for goodwill. The series discusses the economics of goodwill, examines the limitations of the current accounting framework, and proposes opportunities for improvements to the framework.