Last week two Irish companies- Ryanair and the food company Glanbia- endured harsh experiences on the stock market.
Both companies had provided mid-year updates on the financial performance of their businesses. Each witnessed a sharp sell off in their share prices that cannot alone be explained by the latest financial outlook in their statements.
Certainly, both companies advised that profitability prospects had dimmed for the rest of 2019. In the case of Ryanair, this was largely attributed to intense competition, excess capacity in the European market and reduced consumer demand.
Despite a 20% fall in its share price over the past three months another 10% was lopped up after the results were released even though the company kept with the lower guidance it provided a few weeks previously.
Its shares were down 22% since June yet they fell another 15% when the new guidance was disclosed. In both cases, the magnitude of price declines was far greater than the actual cut in profit guidance from each company.
To understand why, we have to enter the somewhat arcane world of stockmarket valuations.
Share prices are a construct comprised of earnings - profit - per share multiplied by a price earnings ratio (PER). A PER of 10 times and earnings per share of €1, for example, explains a share price of €10.
A higher PER is paid by investors if they believe a company has sustainable long-term growth prospects. When investors question that projected growth they will often lower the PER which they will pay for a share.
Hence, a company with unchanged earnings per share of €1 could see its share price decline by 30% if investors decide its PER should be 10 times earnings instead of 15 times. This is what has happened to both Ryanair and Glanbia in recent months. In effect, the market is having a very public debate about the growth prospects of both companies.
It is worth noting that the two groups continue to have enviable financial strength while this is occurring. Ryanair has the strongest balance sheet among European airlines. Its profit per passenger continues, despite recent setbacks, to be among the best in the world.
It pumps out prodigious amounts of cashflow each week. Glanbia maintains a return on capital employed of over 10% even after its warning. Its debt continues to be a comfortable 2.1 times its profit. Many companies would consider these types of financial metrics with considerable envy.
Nonetheless, both companies have a challenge ahead. If they truly believe that their businesses warrant growth multiples then their share prices have ample room to move up over coming quarters.
However, I suspect investors will require stone cold evidence to support such a re-rating. That evidence can only come with a succession of financial results that show the two companies have the attributes needed to deliver consistent growth in profitability.
If they do, then their share prices could prove a bargain today when viewed in retrospect a couple of years hence. If they fail to generate the type of growth they aim for then the shares will languish even though both companies could trade profitably while expanding in their respective markets.
These are the vagaries of the stockmarket. It sometimes feels like a game of snakes and ladders for grown-ups. If things are going well the shares make material gains in a short period.
A market update which disappoints can prompt a sharp slide backwards which spooks both employees and investors. Navigating through all this requires deft management, good strategic decisions and a large dollop of patience.
Joe Gill is director of origination and corporate broking with Goodbody Stockbrokers. His views are personal.