Traders and investors generally view earnings season in a different light.

Traders are interested in what the price of a security is going to do next. They see periods of heightened volatility as an opportunity to make money and welcome the potential for fresh data to move stock prices.

Investors are more interested in a business’s long-term trajectory and whether their thesis (their reason for buying and holding the stock) is reflected by developments in the company’s operations. Or, at the very least, not completely ruled out by them.

Either way, earnings releases can cause markets to quickly reassess a company’s share price. This will generally happen if the market’s collective view of the future appears to have been too optimistic or pessimistic.

A rich share price valuation is usually a reflection of high hopes for the future. These companies and their shares have a higher bar to clear in earnings season. Investors want – and more importantly expect - to hear good news.

A quick screen for ASX-listed shares with one or two star Morningstar ratings identifies a few companies that could be priced for perfection or the next best thing.

3 ASX shares with lofty valuations going into earnings

Valuations reflect investor expectations for the future. A company trading at a significant premium to our fair value estimate indicates the market has higher future expectations than our analysts. Our analysts believe market optimism is misplaced.

This isn’t to say that the companies named here won’t announce stellar earnings and see their share prices rise further. That can and does happen.

This also isn’t a call to automatically sell these shares. A sell decision includes several other considerations like taxes and your broader investment strategy. Read this article by Mark and learn how to craft your investment strategy.

Cochlear ★

  • Fair Value Estimate: $220
  • Share Price July 31: $343.73
  • Economic moat: Wide

Cochlear (ASX: COH) is the market leader in cochlear implants, which became the standard of care many years ago for children in developed markets with profound hearing loss or deafness. With this market segment largely penetrated, the company is looking elsewhere for growth with developed-markets adults the next primary focus and emerging-markets children after that.

Our Cochlear analyst Shane Ponraj views Cochlear as a wonderful business that can earn excess returns on capital for at least 20 years. His Wide Moat rating stems from a combination of Cochlear’s brand recognition and switching costs for patients once an implant is installed. The fact that parts from other vendors won’t fit Cochlear devices also makes its service and replacements business an almost annuity-like revenue stream.

Cochlear has around 60% market share in the infant market, which is essentially fully served by this point and growing roughly in line with birthrates. Ponraj therefore expects most of Cochlear’s growth to come from rising upgrades and accessories revenue in the installed base, as well as growing adoption of Cochlear devices by seniors. It’s worth noting, though, that hearing aids remain the standard of care for seniors as opposed to cochlear implants.

Ponraj also expects some growth from emerging markets despite the company not making this a key priority. Taken together, he thinks that Cochlear can grow its revenue by an average of 11% over the next five years and can grow adjusted profits at closer to a 15% clip.

Those are very healthy numbers, but the current share price of $342 (compared to Ponraj’s $220 fair value estimate) suggest that the market will demand even stronger performance from Cochlear in future years.

Breville ★★

  • Fair Value Estimate: $20.00
  • Share Price July 31: $29.14
  • Economic moat: Narrow

Breville (ASX: BRG) has carved out a premium position in small appliances. The company’s brand strength – and the visible nature of its products in potential customers' houses – has afforded it elements of pricing power. This has helped Breville enter new markets in North America and Europe with some success.

Our Breville analyst Angus Hewitt expects Breville’s traction in high income foreign markets to continue. He is also roughly in line with consensus estimates for the company’s near-term earnings. But he has a different view on the company’s long-term growth potential abroad.

Hewitt thinks that much of the low-hanging fruit has been picked already and that new markets like Mexico and Portugal could prove less lucrative than the UK and Germany. As a result, he thinks the market is overly optimistic about how much, and for how long, Breville can grow internationally.

Hewitt forecasts that Breville's revenue growth could average 6% per year over the next decade as returns from its expansion into new markets slow. He does, however, expect the company to keep more of this company as profits.

He estimates 9% earnings growth over the next decade – which is nothing to sniff at – and offers up a Fair Value estimate of $20 per share. The market’s rosier view of Breville’s future is reflected in a current share price of around $29.

Goodman Group ★

  • Fair Value Estimate: $24.00
  • Share Price July 30: $34.91
  • Economic moat: Narrow

Goodman Group (ASX: GMG) is one of the world’s premier developers and managers of industrial property projects and investments. The group was co-founded in Australia by Gregory Goodman who remains CEO, and now has projects and customers in Asia, Europe, and the Americas.

A typical Goodman project involves obtaining a development site, signing tenants onto leases, and attracting investors who pay for the development and buy the completed project. Goodman typically retains a minority stake and continues to manage sites after completion, collecting development fees, leasing fees, management and performance fees, and a share of rent.

The group’s development pipeline has grown substantially, driven by the race to build e-commerce capability, modernize supply chains, and strong demand for data centers. Most of the group’s development projects end up in Goodman managed investments, boosting the group’s assets under management enormously.

In addition to sticky base revenues, they think that Goodman’s variable income (mostly performance, development and transaction fees) could remain elevated for the next few years. This could come from further e-commerce, supply chain and data center investments supporting demand for the kind of industrial property that Goodman specialises in.

Our analysts expect these trends to continue for the next few years as the race continues for the best logistics and data center sites. However, our analysts expect the remarkable returns to eventually slowdown to a more modest level. First, there is only so much existing property that can be sold and developed, before new sites need to be acquired, likely at substantially higher prices. Second, we see much greater competition in future as many rivals are growing their presence in industrial property.

Our analysts expect Goodman’s assets under management to double over the next ten years due to supportive secular trends and the fact that investments in Goodman funds are often locked up for several years. Goodman’s scale could also see costs fall as a percentage revenue and bring about higher profit margins. However, our analysts also expect competition from rival REITs to pressure management fees. Performance fees could also moderate if the recent surge in asset values slows.

At current levels of around $35 per share, Goodman shares trade around 66% higher than our Fair Value estimate. Our analysts are sanguine on the future for Goodman Group – but the current stock price, not so much. It bakes in a lot of optimism.

Watch and wait?

The three companies mentioned this article are not bad businesses.

In fact, our analysts think they have with durable competitive advantages and the ability to earn excess returns on capital for an extended length of time. Our analysts also feel the earnings outlook is relatively good for all three companies.

A potential problem, though, is that a bright future already seems to be priced in – and then some. Any bumps on the way could lead to a correction in share prices. For long-term investors, any such event could provide an opportunity to own these companies at a cheaper price. For more on reporting season:

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

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