When an expensive stock is not expensive at all

Written by Alessandro Pasetti for Motley Fool

There are certain stocks that investors consider to be expensive simply because they trade high based on trading metrics such as price-to-earnings ratio, enterprise value (EV) to earnings before interest, taxes, depreciation and amortisation (EBITDA), and EV to revenues.

But take ARM, a British chip designer, whose stock: a) trades at its one-year high; b) has risen 30% since mid-October; c) has been recently added to Citi's focus list and Goldman's conviction buy list (this is not necessarily a good sign, as others will have noticed!); d) and trades at 50x forward earnings, and 18x EV/revenue.

Or consider Ted Baker, just a British retailer, whose shares have been on my wish list since they traded at around £19 in June, and now change hands above £23. The implied pre-tax return on your investment, excluding dividends, would be about 20% in half a year. Ted trades at almost 30x projected earnings, and 3x/EV revenue.

The shares of these two companies - which trade at higher multiples than the FTSE's - as well as those of other apparently "expensive" candidates should deserve attention, even in this market. But how do you identify them?

In short, it goes down to size, fundamentals (P&L, balance sheet, cash flow statements), track record and management.

How to select shares: free guide

Growth/free cash flow/size

Both ARM and Ted have grown their businesses a lot over the years, but they are still relatively small players in their respective markets.

As I noted in June 2014, Ted's revenues and operating profit (Ebit) had doubled to £320m and £40.6m, respectively, in the four previous years, which testifies to the management's skills. If current expansion plans are successful, which I think is likely, revenues and Ebit will continue to grow, yielding a significant rise in earnings and dividends per share.

ARM isn't too different, really, having recorded an impressive operating performance over the years. Its management team knows how business is done and how to manage expectations. Of course, both companies present healthy free-cash-flow profiles.

Balance sheet

ARM and Ted have strong balance sheets and could easily raise more debt - higher leverage would boost return on equity. Short-term volatility shouldn't be ruled out, but that's an obvious risk for all entities that must report on a quarterly basis. ARM, in particular, could benefit from favourable exchange rates movements.

Virtually debt-free, both companies could also attract takeover bids. Ted Baker is an ideal target for private equity, which could lever up Ted's balance sheet and deliver terrific returns if its strategy is properly implemented abroad. ARM has been often rumored to be a target for Intel, and we'll see how that goes. This is not the main reason why investors should add these two stocks to their portfolios, but it's one element I like.

How to select shares: free guide

Expensive stuff

Expensive stocks, for instance, are those of Diageo and SABMiller, in my view. In recent times both companies have struggled to grow revenue and Ebit, and operate in an industry that has been in restructuring mode for years. Emerging-market exposure adds risk, too.

Diageo and SAB are market leaders, so any tie-up would be difficult to execute, but the shares of both price in takeover premiums. Not only their shares trade high based on their relative valuations - about 20x earnings for Diageo, and 22x for SAB, on a forward basis - but their balance sheets also carry billions of debt, which is manageable overall, but gives them little room for action with regard to shareholder-friendly activity.

Now, if you think I am right, you must learn more about one particular stock boasting high trading multiples, but whose fundamentals are rock-solid, just like those of ARM and Ted. So, I urge you to you read our latest free investment report, which identifies a few similarly appealing candidates that have delivered a 20% performance in the last quarter alone.

If you are seeking high returns you are in the right place, as we think we have the investment for you. Our report doesn't cost you a penny: it is completely free and comes without further obligations. Click here now to get your free copy.

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