DIPLOMA (LSE:DPLM)

640.0
Today's low: 627.0
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643.0
Today's high: 650.0
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Last trade:
640.0
Change:
 2.0 (0.31%)
Volume:
203,305
Delayed price:
16:35:10
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GBX

Targeting Diploma

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:

  1. The usefulness of average earnings for valuing a growth company
  2. 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:

  1. 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).
  2. 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.

Comments

Very interesting Richard. I've been looking at the exact same thing and have come across various ways of deciding on what starting PE is reasonable for a given level of growth.

There's the old PEG system, which is nice and simple, you can average growth over x years in the past and, assuming you think the company has a fair chance of achieving this, project it forward. Then a starting number is a PEG of 1, i.e. current PE is no higher than the expected growth rate.

Getting a little more clever but not necessarily any better, is the old Graham system of saying PE = base number + (growth multiplied by some factor), of which I think he used PE = 8 + 2G, although he was using it more to stop investors paying daft prices rather than looking for bargains. That amoung gives a rather high PE, so an alternative is something like PE = 6.5 + 0.5G, which is an approximation of the discounted cash flow valuation using a 15% discount rate. So if you project 10% growth then a starting PE of 11.5 is perhaps a bargain, 20% would give 16.5 etc.

As for saying that at a PE of 20 you only get 5% return, well yes in terms of earnings, but the growth investor is typically expecting the PE to stay around that level and therefore if earnings growh by 10 or 20% a year then the share price can be forecast to grow at that rate. At least that's one way of looking at it.

Also you can do things like looking at the current earnings, the projected earnings growth and any dividends at the average payout ratio and project all that forward for the next 10 years. Then you can guestimate the share price at the average PE of the last 10 years and work out your total income and capital gains to any year assuming the PE reverted back to its average value. That's quite an interesting projection. You can then adjust your forecast to be more pessimistic, and/or look at the returns if the PE was at historic highs or lows etc, to get a feel of the range of possibilities the future may hold for that company and its shares.

Hi John, good to hear from you.

I must admit I hate this particular blog post. It is so predictable. Every time I try to base the case of an investment on future expectations for a company I bottle it.

The problem with the PEG (according to Keith Anderson - a finance lecturer at York Uni) is that there is no statistical evidence it works. I was co-writing a book with him for a while (that I have shelved, but he is continuing with) and his stats seemed reasonably convincing.

Alternatives (including DCF) seem like a variation around a similar theme. The problem is that growth is, generally, mean reverting. Apples and Microsofts are the exception.

I'm about to publish an explanation of Dylan Grice's intrinsic value to price calculation which is a variation of Stephen Penman's residual income model. He (Grice) uses historic ROE as a basis for future earnings (Penman uses earnings forecasts) and I think you will find it very interesting. I can tell you now though, his method still penalises the Microsofts of this world.

If you want to invest in those you have to be able to differentiate between sustainable growth companies from companies that have grown a bit, and I'm really not sure that can be done statistically.

So I've defaulted to standard value position (which I think is broadly true of Graham, although at various times he may have tried to factor growth in to his calculations), which is that past growth is positive, but I won't pay much for it.

I have no doubt you'll see me wringing my hands over this one for decades to come...

Disclaimer: I own DPLM as from earlier this year. Its share price slid slowly during that time, but it has had a recent dramatic burst on the back of excellent results. The recent director's management statement was very positive, and states that profits for y/e Sep 2011 will be materially ahead of market expectations. It's on a PER of about 15 - not excessive by any means - and pays a divvie of about 3%. The balance sheet is very strong. The directors have been buying shares during February and March - although the price has crept up since then. Admittedly, purchases were on a fairly modest scale.

If you want further encouragement, on a Greenblatt filter I ran just now, DPLM came in at 31st position on a list of 385. So it is in the top 10%, which I think is pretty good, especially seeings as I think the majority of shares higher in the list are quite weak financially.

I'm pretty bullish on this one; although far be it for me to say that your PE10 measurement criteria is "wrong".

Just in passing, now that I've mentioned the Magic Formula, Unilever, another stock I own, is very high on the list; and has to be one of the safest companies on the stock market, too. Not one to shoot the lights out, though. Also high on the list is PIC (Pace), a company that so far has proved ... ahem ... "vexatious" for me. Yeah, laugh it up. Still, at a PER of less than 7, a lot of negativity has been priced in ... in theory, anyway.

Hi blippy, good to hear from you as always. I'm very nervous about relying on one year PE's, especially if they're based on forecasts, which in turn are extrapolated from recent good results in the previous year. I'm trying to value it using a version of the Residual Income Model (briefly mentioned here: http://blog.iii.co.uk/intrinsic-value-the-holy-grail-of-value-investing/ ), which is very fiddly, and probably just as prone to optimism! I'll let you know what I learn.

One thing though, I think Diploma is more attractive than its high market valuation implies (high in my estimation), because of its strong balance sheet. I doubt many of the companies in the same sector with higher ROEs are unleveraged (though I haven't checked).

Good luck with it, and Unilever and Pace. Unilever does crop up on my screens occasionally but I've never seen Pace in them.

Richard.

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