Weighing up whether a company’s prospects justify its valuation isn’t always easy when it comes to businesses that are growing at a fast rate. However, of the two growth stocks I’m looking at today, I feel confident enough to rate one a ‘buy’ and one a ‘sell’.
Bright future
I’m convinced that FTSE 250 respiratory drugs and devices group Vectura (LSE: VEC) has a bright future, as both a business and an investment.
Vectura merged with Skyepharma last June and the increased scale and breadth of the group give it the potential to develop into a respiratory powerhouse, as it competes across all the major respiratory classes.
In a pre-close trading update earlier this month, the company said that revenue for 2016 is anticipated to be in line with the board’s expectations and that positive momentum from seven key recently-launched inhaled products provides a strong base for recurring revenue. Chief executive James Ward-Lilley also reported “significant progress” with the company’s pipeline of products.
Vectura’s 2016 financial year is a shortened one of nine months as, since the merger with Skyepharma, it’s changed its year-end to 31 December, to align with its partners and peers. As such, I look to the forecast financials for the full-years 2017 and 2018 for my valuation. At a share price of 130p, these give a P/E of 16.6, falling to 10.9 and a P/E-to-growth (PEG) ratio of 0.2, which offers tremendous value.
Based on the attractive valuation and long-term demographics of ageing populations in the developed world and rising prosperity and demand for healthcare in emerging markets, I rate Vectura a ‘buy’.
Overvalued?
AO World (LSE: AO) has come along way under founder and chief executive John Roberts since he bet a friend a pound that he could change the way white goods are purchased via the Internet, way back in 2000.
The company is well-managed, has grown rapidly in the UK, is expanding into Germany and the Netherlands, and says its “on a mission to become a leading European online retailer of electrical products”.
But — yes, there is a but — the company is still forecast to be loss-making for its financial year ending 31 March. For fiscal 2018, the forecast is for pre-tax profit of just £3.7m on turnover £860m and while profit is forecast to rise to £16.1m for fiscal 2019, it will take a whopping £1,018m of turnover to produce it.
In other words, this is a low-margin industry, which doesn’t appeal to me as an investor. Small profits can easily swing to large losses when margins are thin, whether due to the company making a misstep or external forces beyond management’s control.
And speaking of external forces, the company said in a third-quarter trading update earlier this month that while it expects full-year performance to be within its previous guidance, it’s “cautious about the final quarter given the uncertain UK economic outlook, currency impacts on supplier pricing and the possible effect on consumer demand”.
Based on the potential for AO World to suffer a setback at some point in its expansion and a sky high valuation (a P/E of 245 for 2018 and 53 for 2019), I rate the shares a ‘sell’ at a current price of 159p.