SKY (LSE: SKY) and BT (LSE: BT-A) have recently become FTSE 100 darlings. Investors have clamoured to get their hands on the shares of the two companies during the past 12 months and as a result of this stampede, valuations have been pushed to historic highs.
For example, since August last year, BT’s shares have jumped 23%, and Sky’s shares have risen 28% — excluding dividends. Over the same period, the FTSE 100 has only added a lacklustre 2.2% excluding dividends.
But BT and Sky’s outperformance has had little to do with business performance. According to City figures, BT’s earnings per share are set to fall 3% this year. That said, analysts believe Sky’s earnings per share are on track to grow by 14% during 2015.
Nevertheless, over the past year BT and Sky’s valuations have exploded, and it’s now debatable whether the companies deserve their lofty valuations.
In particular, BT currently trades at a forward P/E of 15, its highest valuation since the dot-com bubble. Similarly, Sky trades at a forward P/E of 18, a multiple not seen since 2007.
However, these valuations don’t necessarily mean that investors should avoid the two companies.
Crunching numbers
The stock market is just like any other market unless there’s a big sale going on, you will have to pay a premium to buy a quality product.
BT and Sky are two premium products. In fact, you say that they are the most exclusive product in their category.
Sky’s recent deal to merge with its European counterparts has made it one the largest pay-tv providers in Europe while BT is the biggest telecoms company in the UK.
And Sky’s premium valuation is justifiable in several other ways as well. The company has been able to achieve staggering returns for investors over the past five years. Group return on equity (profit earned in comparison to total shareholder equity) was 64% last year and has averaged around 80% since 2010. What’s more, last year the company generated 100p per share in free cash flow.
These impressive performance metrics have helped Sky increase shareholder equity at a compound annual rate of 41% since 2010. Book value per share over the period has risen from 32p to 184p as reported at the end of last year. There are not many other companies out there that have been able to achieve this rate of growth. Since 2009 Sky’s shares have outperformed the FTSE 100 by 125%.
BT’s returns have been more muted, and there’s a dark cloud hanging over the company in the form of a multi-billion pound pension deficit. Moreover, the company’s market dominance in the UK is currently being investigated by regulators. If regulators decide to break BT up, the company will lose one of its most impressive qualities; size. As a result, it would become harder to justify BT’s lofty valuation.
So overall, Sky’s high valuation can be justified but BT looks overvalued at present.