Case 043Investment evaluation and pitchesWarm up

Saptaparni Pharma beat the quarter by 8%, cut next year's guidance by 10% and fell 12%. Split the fall into the earnings revision and the change in multiple, and say what moved the stock.

Balyasny Asset ManagementChicago · 2021

The situation

Saptaparni Pharma closed at Rs 1,000 the day before results, with the street expecting next year's EPS of Rs 46. The quarter came in 8% above expectations. On the call, management cut next year's guidance to Rs 41.4, citing pricing pressure in one export market. The stock closed at Rs 880, down 12%.

A portfolio manager asks: the quarter was good, so why did it fall, and how much of the fall is earnings and how much is the market changing its mind about the multiple?

Your task

Decompose the Rs 120 fall into an earnings effect and a multiple effect, and explain why a beat can coincide with a fall.

Quick check

The stock fell 12% on a 10% guidance cut. What does that say about the forward multiple?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Of the Rs 120 fall, about Rs 100 is the earnings cut and about Rs 20 is the multiple. Before results the stock traded at 21.7x next year's Rs 46. Apply that multiple to the new Rs 41.4 and you get Rs 900: the 10% cut costs 10% of the price. The last Rs 20 is the forward multiple slipping to 21.3x. The beat did nothing because it was already history; prices move on changes to the future, and the future got worse.

Step 1Why does a good quarter not stop the stock falling?

A landlord does not value a flat on last month's rent; she values it on the rent it will earn from now on. If the tenant pays this month early but gives notice, the flat is worth less, not more. A share price is the market's estimate of future earnings times what it will pay for them, so only news about the future moves it. The 8% beat told the market about a quarter that is over; the guidance cut told it about every quarter to come. Only one of those changes the valuation.

Step 2How do you split the move into earnings and multiple?

Price equals EPS times the forward P/E, so a change in price is a change in one, the other, or both. Hold the multiple fixed first. At the old 21.74x, the new EPS of Rs 41.4 is worth Rs 900, so the earnings revision explains Rs 100 of the fall. Whatever is left is the multiple: Rs 880 on Rs 41.4 is 21.26x, and -0.48 turns of multiple on Rs 41.4 of earnings is Rs 20. The de-ratingA fall in the multiple the market pays for a given level of earnings, separate from any change in the earnings themselves. was small; the market mostly took the new number at face value.

The relationship
ΔP=(E1−E0) M0⏟earnings+(M1−M0) E1⏟multiple=(41.4−46)×21.74+(21.26−21.74)×41.4=−100−20\Delta P = \underbrace{(E_1 - E_0)\, M_0}_{\text{earnings}} + \underbrace{(M_1 - M_0)\, E_1}_{\text{multiple}} = (41.4 - 46)\times 21.74 + (21.26 - 21.74)\times 41.4 = -100 -20
E_0, E_1forward EPS before and after the guidance cut
M_0, M_1forward P/E before and after, price divided by forward EPS
Delta Pthe Rs 120 change in price
What it says in wordsChange the earnings at the old multiple, then change the multiple on the new earnings; the two pieces add exactly to the move.
Where did Rs 120 go? Almost all of it is the earnings cut, not the multiple8009001,000Rs 1,000before results+0quarter beat 8%already in the past-100EPS cut 10%at 21.7x-20multiple21.7x to 21.3xRs 880after resultsRs 900 = 41.4 x 21.74
Saptaparni's fall from Rs 1,000 to Rs 880 is Rs 100 of earnings cut at the old 21.7x and only Rs 20 of multiple slipping to 21.3x, while the 8% quarterly beat adds nothing because it is already past.
BeforeAfterChange
Forward EPS, Rs46.041.4-10%
Forward P/E21.74x21.26x-2.2%
Price, Rs1,000880-12%
Earnings effect-100
Multiple effect-20
A 10% earnings cut and a 2.2% lower multiple compound to a 12% fall; the earnings effect is five times the size of the multiple effect.
Step 3What should the portfolio manager take from the split?

The market has not lost faith in the business; it has repriced the earnings and left the multiple almost alone. That is a very different situation from a stock that falls 12% on unchanged earnings, which would be a change of view about quality or risk. Here the question for the manager is narrow: is Rs 41.4 the right number? If the pricing pressure is one market and one year, the earnings come back and the stock follows. If it spreads, the multiple will be the next thing to go, and 21.3x is still a full price for a pharma company with falling estimates.

The limit of the method: the split depends on which number you call earnings. Use the same forward year before and after, and the same consensus source, or the decomposition mixes a change in the estimate with a change in the estimator. And when the cut was an estimate rather than guidance, the multiple effect absorbs whatever the market thinks the real cut will be.

Where candidates lose it

The common loss is explaining the fall by the quarter and concluding the market is irrational. The quarter is history; the guidance is the future, and the stock is priced on the future.

The second is computing the multiple effect on the old EPS rather than the new. The two pieces only add to Rs 120 if the multiple change is applied to Rs 41.4.

What the interviewer asks next

  • If the cut were to this year's EPS only and next year was unchanged, how would you expect the stock to react?
  • A peer with the same export exposure fell 4%. What does that tell you about the read-across?
  • How would you present the same decomposition for a stock that fell 12% on no change in estimates?

Asked at Balyasny Asset Management, Equity Hedge, Chicago, 2021 (Wall Street Oasis): When moves a stock? How to think about valuation drivers?

Company names and figures are illustrative.