To be a good investor you must be able to understand why shares are moving in a certain direction. Greggs’ (GRG) 12.5% share price drop on 1 October upon publishing a new trading update is a perfect example to study.

At first glance, the trading update looked very positive and so the large fall may have been difficult to comprehend. But once you obtained a better understanding of its situation and weighed that against its stock market valuation it was easy to see why the shares fell.

Greggs’ shares have been fuelled by three things over the past year – earnings upgrades, investors happy to pay a higher rating for the stock and the company being one of the few ways for UK investors to play the fast-growing vegan theme.

The business has historically traded in a price-to-earnings range of 16 to 25-times but this valuation jumped up earlier in 2019 when the launch of its vegan sausage roll generated significant publicity and led to more people visiting its stores.

It wasn’t a one-off boost either. Greggs  continued to report strong trading as the year progressed, leading to a series of upgrades from analysts as they raised their future earnings estimates again and again.

This euphoria around trading strength resulted in investors being willing to pay a higher rating for the shares, thereby creating another catalyst for the share price in addition to earnings.

The accompanying chart shows how its price-to-earnings ratio jumped beyond the historic range this year. The data in the chart is based on historic earnings – you would normally need to focus on forecast earnings to get a sense of what the market is thinking but the chart still provides a good illustration of how the valuation got out of kilter.

At the same time the vegan movement hit the mainstream and investors scrambled to find ways to invest in it. The UK stock market has very little on offer for this theme, meaning Greggs was the natural choice for many hoping to profit from increased demand for plant-based foods.

Taking all these factors into consideration you can perhaps understand why everyone wanted to own a slice of Greggs from an investment perspective.

It meant expectations were very high leading up to the trading update on 1 October. Everything was riding on the company once again beating expectations and Greggs saying there was still big interest in its vegan products.

Sadly neither happened so the shares quickly started to de-rate as investors were no longer prepared to pay such high earnings multiples given how some of the key catalysts had potentially played out.

The vegan angle arguably still has legs. Greggs is planning to launch vegan versions of its entire product range, according to reports. But the lack of earnings upgrades this time may ultimately see the shares struggle in the near-term.

Watch this webinar for more on Greggs’ debate and what valuation ratios can tell you. 

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