Higher interest rates have have reduced PE (price to earnings) ratios across the market with the brunt of the damage suffered by highly-rated growth shares.

With only one in six stocks in the FTSE-All Share trading above their 200-day moving average, Shares investigates whether some names may unfairly have been caught up in the indiscriminate selling.

This article reveals some of the biggest deratings and reratings across the UK market. The idea is to identify stocks which have been unreasonably punished by the market. Also highlighted are stocks which have seen an increase in PE, bucking the general derating trend.

WHAT IS A DERATING?

A derating refers to a falling PE ratio while a rerating refers to a rising one. It typically means the share price is out of kilter with the growth in earnings.

It should be remembered that in the long run, earnings per share and cash flow growth are the main drivers of shareholder returns. However, a rising PE alongside rising earnings can be very powerful.

An example will illustrate the effects. If a company can grow earnings by 7% a year, they will double over 10 years. The rule of 70 can be useful here. Simply divide the growth rate into 70 to approximate how many years it takes earnings to double.

If earnings are 10p per share and the PE is 10, the share price will be 100p. In year 10 earnings will be 20p per share and assuming the PE remains the same the share price will be 200p.

But if investors become more positive due to the earnings growth and raise the PE to 20, in year 10 the share price will be 400p, for a four-fold return.

HOW THE SCREENS WERE CREATED

Using Stockopedia software Shares has created two screens which highlight some of the biggest deratings and reratings over the last five years.

The method applied is to compare the forecast PE for the current financial year to the average PE over the last five years.

To ensure a derating isn’t down to a failing business which has gone ‘ex-growth’ the screen stipulates a five-year CAGR (compound annual growth rate) in EPS (earnings per share) of at least 10%.

To focus on the most interesting names, the screen identifies stocks which have suffered at least a 30% derating.

The 23 companies that qualify have grown their earnings by an average of 25% a year over the last five years while their combined share price is up just 2% on average. On average the group has seen its PE rating halve over the last five years.

Encouragingly, the group has seen its earnings estimates increase by an average of 17% since the start of the year, demonstrating continued business momentum.

WHO’S ON THE LIST?

It is very difficult for any company to maintain a high pe because of the law of large numbers. Doubling the size of a business with £100 million of profit is far easier than one with £1 billion of profit.

Therefore, as companies ‘grow into’ their valuation the pe rating tends to revert to a long term mean or average, creating a natural headwind for shareholder returns.

Digital e-learning software company Learning Technologies (LTG:AIM) is a good example.

Maintaining a PE in the 70s implies a lot of future growth. Despite the high hurdle the company has delivered a five-year EPS CAGR of 74% a year. The average UK company delivers EPS growth of around 6% a year.

Despite the supercharged growth the PE ratio has fallen 88% to just 13 times, assuming the company meets full year analysts’ forecasts.

That looks like a decent bet given that full-year EPS forecasts have almost doubled in the last 10 months. The shares have halved over the last year.

The brutal derating of Learning Technologies could represent a great buying opportunity, or it may signal investors believe the company has gone ex-growth.

Although analysts expect the company’s long-term growth rate will subside to around 43%, that would still justify a higher PE than the market. For reference the FTSE All Share trades on a PE of 10 with expected growth of 7.4% according to Stockopedia.

How much of a premium is a difficult question to answer, especially when interest rates are expected to increase further.

Other highly rated companies making the final cut include veterinarian services company CVS (CVS:AIM) and video games services supplier Keyword Studios (KWS:AIM).

Both companies have been derated by 70% despite delivering five-year earnings CAGR of 21% and 32% respectively and have seen full year earnings estimates revised upwards.

At its full year results (23 September) CVS said it had seen strong like-for-like sales growth in the first 10-weeks of the new fiscal year while it had a healthy pipeline of potential deals.

Despite a difficult consumer backdrop with several peers issuing profit warnings, food-on-the-go firm Greggs (GRG) served up a surprisingly positive trading update for the third quarter to 1 October.

Like-for-like sales from company-managed stores were up 9.7% year-on-year and the company maintained full year earnings guidance.

WHICH COMPANIES HAVE SEEN THEIR VALUATIONS INCREASE?

Some companies have seen a rerating over the last five years which may reflect improving fundamentals or at least better investor sentiment.

In the case of pawnbroker and jewellery retailer H&T (HAT:AIM) it looks like a bit of both. After many years of going nowhere, the shares broke out to new all-time highs in July as macro-economic clouds were building. The shares are up 50% year-to-date.

H&T’s services are expected to be more in demand as cash- strapped consumers look for alternative forms of financing and swap good for cash.

Earnings revisions for 2022 have increased by around 10% while estimates for 2023 are up almost 50%.

Not all growth stocks on high PEs have succumbed to share price weakness. Shares in telecoms billing and software company Cerillion (CER:AIM) hit new all time highs in early October taking year-to-date gains to 35%.

The shares trade on a PE of 39 which means they have rerated by 43% over the last five years. Earnings growth has been supportive with a five-year CAGR of 43%.

Looking forward analysts have pencilled in 20% eps growth for the year to 30 September 2023 after growing by an estimated 44% this year. In a recent trading statement (24 October) the company said earnings are expected to be marginally ahead of market forecasts.

Canaccord Genuity noted the beat is the fifth in the last 18 months and supports the thesis that the company’s growth drivers are ‘immune’ to macroeconomic factors. Cerillion is benefitting from the push from telecom operators to upgrade and digitise their operations.

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