I was already apprehensive about Diploma’s price when I profiled the company last week.
One day later, before I’d had a chance to check my theory that it’s a hidden champion against its financial record, Diploma published a trading statement reporting strongly increasing sales and profits in the half year closing at the end of this month.
The price, which was 264p (valuing the company at 24 times ten-year earnings), is now 318p, valuing Diploma at 28 times ten-year earnings.
Rather exasperatingly that would make what looked like a very good company even more difficult to add to the Thrifty 30 portfolio.
The events prompted a debate in the comments section about:
- The usefulness of average earnings for valuing a growth company
- The maximum multiple of earnings a value investor should pay.
If Diploma keeps growing over the next five years as fast as it has over the last five, it’s obviously going to make a lot more profit, so using past averages as a guide is a waste of time. Using last years earnings figure, the plain old historic PE might be a better guide. Unfortunately it’s also pretty high, at 17.
Let’s call it 20 to keep the arithmetic simple. The case against paying twenty times earnings, assuming earnings stay constant in future, is you can only expect a 5% annual return on your investment in a typical year (i.e. you only get 1/20 of your investment back in profit). There are surely more lucrative investments to be made.
Of course we already know Diploma’s revenues in the first half of this year are 16% higher. I could assume the company grows it’s earnings, say 10% a year for the next five years. Then at the end of its financial year in 2015 its earnings will be 61% higher. The price now is only 12 times Diploma’s ‘forecast’ earnings in five years time, and that’s approaching bargain territory. At least it promises a return of more like 8%.
The problem is, the company is only a bargain if events unfurl as expected (and let’s face it I made the 10% growth figure up – it’s roughly the growth rate of the last five). I’d rather invest in a company that promises these returns now, even if business isn’t better than it was in the past.
But this is not the end for Diploma and I. The company publishes its annual reports for the last five years and I’ve requested the previous five. Judging by the ones I’ve got it looks like a highly profitable, conservatively financed company, and the consistency of its stats, albeit over a fairly short period, suggests it could be a hidden champion.
In other words its competitive advantage may last, which makes continued growth more likely.
The conservative in me just doesn’t want to pay growth company prices for growth companies. Instead, I’m going to make Diploma the first member of a new list, a watch list of potential hidden champions that will remind me to:
- Consider them for the portfolio, should their prices drop (Diploma’s price fell below 100p during the credit crunch, when its one year historic PE was just 6).
- Learn more about their businesses, because basing your case on the strength of the business requires considerable confidence.
Next time I run my hidden champions stock screen I’ll cap it at 25 times average ten-year earnings. If companies are so popular they cost more than that, I can only assume they’re not well hidden!
BTW, I’ve changed the format of the summary table (top) whilst retaining a traffic light system. Diploma gets a red light on market risk, because it’s pricey. But statistically speaking it looks like a great company. Consistently high returns on equity suggest low business risk, and financially it’s a fortress.
About the author
Richard is companies editor of Interactive Investor and a columnist at Money Observer magazine. A keen private investor through his Self Invested Personal Pension, he manages two virtual portfolios. The Share Sleuth portfolio is a hand-picked collection of mostly small-cap value shares, while the Nifty Thrifty is a mechanical portfolio designed to pick large, successful companies at cheap prices.
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