T. Rowe Price (NASDAQ: TROW) has suffered a major decline over the past six months, falling 37% from the 12-month high close of $ 223.87 on August 31, 2021 to $ 140.12 today. The combination of falling equity markets and subsequent outflows from mutual funds has resulted in declining assets under management (AUM). To make matters worse, TROW is primarily an active management shop and the firm has suffered outflows as more money shifts to passive management. Management expects 2022 to be a weak year.
TROW’s earnings have increased substantially over the past several years, but the rate of EPS growth has flattened out and Q4 earnings, despite slightly exceeding the consensus estimate, appear to have triggered a run for the exits. If, as many experts are predicting, the returns from equities are low over the next five to ten years, earnings growth for money management firms such as TROW will be highly constrained. The consensus outlook for TROW’s EPS growth rate over the next 3-5 years is 2.5% per year.
The forward dividend yield is 3.36% and the trailing 3-, 5-, and 10-year dividend growth rates are 15.6%, 14.9%, and 13.3%, respectively. The payout ratio is a very reasonable 33.9% and the company has a 35-year track record of raising the dividend every year. The company obviously has a strong commitment to the dividend. If the weaker growth outlook is realized, maintaining dividend growth rates at levels comparable to recent years will increase the payout ratio. This is sustainable for a while because of the fairly low current payout ratio.
I last wrote about TROW on November 8, 2021 at which time I maintained my overall bullish rating on the shares. At that time, the shares were trading at $ 221. The shares have declined substantially in the subsequent period. When I wrote this piece, the consensus outlook among Wall Street analysts was that the shares were a few percent above the 12-month price target at that time and the consensus rating was neutral. TROW’s solid dividend and demonstrated ability to grow the dividend and earnings over several decades were, and continue to be, a reason to bet on this company. Along with the fundamentals and Wall Street consensus, I rely on the market-implied outlook, a probabilistic price forecast that represents the consensus view from the options market that is implied by options prices. In early November, the market-implied outlook to mid-January of 2022 was slightly bullish, although the outlook to mid-April was neutral.
For readers who are not familiar with the market-implied outlook, a brief explanation is helpful. The price of an option on a stock reflects the market’s consensus estimate of the probability that the share price will rise above (call option) or fall below (put option) a specific level (the option strike price) between now and when the option expires . By analyzing the prices of call and put options at a range of strike prices, it is possible to calculate a probabilistic price forecast that best reconciles the options prices. This is the market-implied outlook. For readers with a quantitative bent who want to understand this approach, I recommend this publication from the CFA Institute. The market-implied outlook is no crystal ball (of course), but provides an additional form of outlook to supplement fundamentals and the Wall Street consensus.
With the substantial decline in TROW, along with the broader equity markets, I wanted to revisit my analysis.
Wall Street Consensus Outlook for TROW
E-TRADE calculates the Wall Street consensus outlook for TROW by combining the views of 9 ranked analysts who have published ratings and price targets over the past 90 days. The consensus rating is neutral, but the consensus 12-month price target is 20.9% above the current price. Back in early November, the consensus 12-month price target was $ 214.8, so the prevailing view among the analysts has become substantially less optimistic in the past 4 months. The spread in the individual analyst price targets is wide, which reduces the overall meaningfulness of the consensus price target as a form of guidance.
Seeking Alpha’s version of the Wall Street consensus outlook is calculated by aggregating price targets from 13 analysts who have updated their views in the last 90 days. The consensus rating is neutral and the consensus 12-month price target is 16.4% above the current share price.
The neutral rating and the 12-month price target that is 16% -21% above the current share price are consistent with a weak growth outlook and shares that are oversold.
Market-Implied Outlook for TROW
I have calculated the market-implied outlook for the 4.4-month outlook from now until July 15, 2022 and the 9.4-month period from now until December 12, 2022. I selected these two expiration dates to provide a view to about the middle of the year and for the balance of 2022. The volume of options trading on TROW is low, so the market-implied outlook should be given a fairly low weight in the overall rating.
The standard presentation of the market-implied outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.
The market-implied outlook for the next 4.4 months is tilted to favor positive returns and the peak probability corresponds to a price return of + 5.25% over this period. The annualized volatility calculated from this distribution is 38%, which is notably high. In my November analysis, for example, the expected volatility was 27% (annualized).
To make it easier to directly compare the probabilities of positive and negative returns, I rotate the negative return side of the distribution about the vertical axis (see chart below).
This view shows that the probabilities of positive returns are consistently higher than for negative returns of the same magnitude across a wide range of the most-probable outcomes (the solid blue line is above the dashed red line over the left side of the chart). This is a bullish outlook for the next 4.4 months.
Theory suggests that the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and thus tend to pay more than fair value for downside protection. The expected bias reinforces the bullish interpretation of this market-implied outlook.
The market-implied outlook to December 15, 2022 has closely matching probabilities of positive and negative returns (the solid blue line and the dashed red line are almost on top of one another). Given the low volume of trading, the most sensible interpretation of this market-implied outlook is neutral. The annualized volatility calculated from this distribution is 35%. For reference, E-TRADE calculates 34% implied volatility for options expiring on December 15, 2022.
The market-implied outlook to the middle of 2022 is moderately bullish and the outlook to mid-December is neutral. The expected volatility is 38% for the middle of the year and 34% for the balance of 2022.
TROW’s high expected volatility motivates selling covered calls on TROW. As I write this, TROW is trading at $ 138.12 and you can sell a December 2022 call option with a strike of $ 140 for $ 14.20 (this is the bid price). Selling this call option provides 10.3% in option premium income over the next 9.4 months, in addition to the 3.4% dividend. Selling this call gives up almost all of the upside potential, of course, but this is a notably high level of income.
TROW has experienced a major sell-off as a result of flattening earnings growth and a weak outlook for 2022. The fundamentals and the company’s long-term track record of growing earnings and dividends serves to offset the near-term outlook, however. The Wall Street consensus indicates that the shares are oversold, with a 12-month price target that is about 18% above the current share price. As a rule of thumb for a buy rating, I want to see an expected 12-month return that is at least ½ the expected volatility (34% for the balance of 2022). TROW meets this criterion. The market-implied outlook is bullish to the middle of 2022 and neutral between now and mid-December. I am maintaining my bullish rating on TROW but I have sold covered calls in light of the high current volatility.