A stock rerating is when a company’s valuation changes, therefore investors will be willing to pay a higher or lower price for the stock. It can happen due to unexpected news or events that drastically affect the company's financial outlook. As the market sentiment towards companies changes, investors will value the stock in a different way. This can happen when the outlook of the company deteriorates or improves, which can move the price both lower or higher respectively.
It is important to understand the correlation between market sentiment and the outlook of the company. Oftentimes investors tend to be driven by short-term events that do not seem to affect the company’s ability to generate earnings in a very long period of time.
Changing financial metrics
A stock rerating is in essence an expansion or contraction of the price-to-earnings ratio. When a company’s future projections change the stock price will adjust. Investors will be willing to pay a higher valuation and a higher price-to-earnings ratio for a stock that has a more positive outlook. Conversely, they will also be willing to pay a lower valuation and price-to-earnings ratio if the company’s estimates deteriorate.
Thus, multiples expanding and contracting tend to be directly related to stock rerating, and how it can change the value of a stock.
What drives a stock rerating?
There are several reasons why a stock could be related, however, it tends to be always related to the company’s outlook. Updated estimates from analysts are one of the reasons that could drive a stock to drastically change its valuation. This can both create upside or downside in the stock, depending on the estimates' improvement or deterioration. Here are some of the main reasons that could drive a stock rerating:
- Changing macroeconomic environment
- Changes in management
- Improved or deteriorated outlook
- Updated analyst estimates
- Market trends
- Competitors outlook
- Changes in management estimates
- Market sentiment
The stock rerating investment approach
Broadly speaking investors are contrarians. When they buy or sell a specific stock, they are betting against the market consensus which has dictated that the price of that stock should be what it currently is. Therefore in order to generate returns, investors are expecting the market’s consensus view on the stock to change.
A contrarian investor looks for stocks that are deeply overvalued or undervalued. Their investment approach is to take the opposite view of the market, in a sense being contrarian to market trends that are the prevalent consensus.
One investment approach that has generated favorable returns, is to look for stocks that are soon to be rerated. This means that an investor with the ability to understand whether a company is overvalued or undervalued and that estimates are bound to change in the short term could try to profit from that. Either going long on undervalued stocks or going short.
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