With the FTSE 100 having hit 7,500 points this week for the first time, it is unsurprising that some stocks are grossly overvalued. After all, the index has risen sharply in recent months, despite uncertainty in the outlook for the global economy. Therefore, growth rates and valuations may not be linked as closely as they perhaps should be. This means that investors may need to be wary when it comes to the price they pay for high-quality stocks.
Impressive performance
Reporting on Wednesday was thermal processing services specialist Bodycote (LSE: BOY). The company has experienced a solid start to 2017, with its revenue increasing by 18%. However, the majority of this was due to weaker sterling. On an underlying basis, its top line rose by 7.1%. Like-for-like (LFL) revenues moved 3.9% higher, with Aerospace, Defence and Energy business revenues moving up 10.8% (0.6% at constant exchange rates). Automotive & General Industrial business revenues increased by 23.2% (11.8% at constant currency), which shows that the company’s overall strategy seems to be working well.
Looking ahead, Bodycote has an upbeat outlook. It is expected to report a rise in its bottom line of 11% in the current year, followed by further growth of 7% next year. While this is an above-average rate of growth, it trades on a valuation which is perhaps more reflective of a growth stock, rather than a company with modestly above-average growth potential.
For example, it has a price-to-earnings growth (PEG) ratio of 2.7. This suggests there is a narrow margin of safety on offer. At a time when there are still a number of enticing stocks trading on low valuations, Bodycote may be a company to avoid for now.
Solid growth
Clearly, there is uncertainty ahead for investors, despite the rising share price levels recorded in recent weeks. Political risk in the US and Europe could cause investor sentiment to come under pressure. Therefore, shares which have proven track records of consistent growth could become increasingly popular. One such company is information services business Experian (LSE: EXPN). It has a long track record of profit growth, with its business model offering stable returns which have generally been in line with the wider index.
While reliable growth companies may be worth a premium to the wider index, Experian’s current valuation suggests it is grossly overvalued. It trades on a price-to-earnings (P/E) ratio of 23.2, which when combined with its 8%-9% earnings growth forecasts over the next two years equates to a PEG ratio of 2.1. This suggests that there could be some disappointment ahead – especially if the macroeconomic outlook deteriorates.
Clearly, Experian is a high quality company with a proven business model. However, its yield of 2% suggests there is a lack of income appeal right now. Alongside average growth and a high valuation, there do not seem to be catalysts to push its share price significantly higher.