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Great expectations of a stock can be its downfall

I’ve written in the past how the stock market is a very emotional place. It is also a place where expectations are built into the share price.

If a company is trading on a high price/earnings multiple it means that the business is expected to generate a lot growth in the future. If it’s trading on a low price/earnings ratio it means that the market isn’t expecting the business to grow much, if at all.

Investors who are trying to beat the market need to assess how much growth the market is expecting of a stock and what the chances are of the stock beating that expectation (or not).

Of course, when a stock doesn’t meet expectations it can lead to a share price fall. We’ve seen quite a few of those. Just this week a2 Milk Company Ltd (ASX: A2M) dropped by double digits after saying its sales would be in the region of NZ$900 million to NZ$920 million for FY18, which wasn’t quite as much as the market expected. I’ve often pondered whose fault is it if the company doesn’t hit expectations, did the company underperform? Or did the market expect too much?

Other businesses like Healthscope Ltd (ASX: HSO), Domino’s Pizza Enterprises Ltd. (ASX: DMP) and Medical Developments International Ltd (ASX: MVP) have all fallen in recent times on high expectations.

Foolish takeaway

A key consideration from this, in my opinion, is to be very wary of shares that have high p/e ratios because there’s a chance they may drop significantly if they underperform. Rising interest rates could also have a big impact on shares that have long-term growth or high-growth expectations built into their prices.

Sometimes it could be much better just to invest into good quality, value stock like this exciting share which is trading with a PEG ratio of less than one.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of A2 Milk. The Motley Fool Australia has recommended Domino's Pizza Enterprises Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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