In raging bull markets, the shares of fashionable growth companies can be bid up to the stratosphere. The idea of growth at a reasonable price goes out of the window, replaced by growth at any price.
The valuations of the likes of Boohoo, Purplebricks and Fevertree Drinks(LSE: FEVR) have reached eye-watering levels this year. And while a degree of sanity has returned, with many such stocks having retreated from their highs, valuations still look seriously stretched to my eye.
Huge growth potential
I'm full of admiration for Fevertree, which has risen rapidly to become the world's leading supplier of premium carbonated mixers. It was single-handedly responsible for 97% of the retail value growth in the UK soft drinks sector over the last 12 months and is also expanding overseas.
Certainly, I wouldn't disagree that Fevertree has huge growth potential the world over. But how much should we be prepared to pay for this potential?
In a trading update on Tuesday, the company said it anticipates this year's results to be "materially ahead of current market expectations." The shares are now trading at 2,100p, valuing this AIM-listed firm at £2.42bn.
Broker Shore Capital has upgraded its revenue forecast to £158m and house broker Investec has moved up to £158.3m. So the company is valued at over 15 times sales. From a value perspective, 10 times sales is my maximum threshold and that would be for a company starting from a low revenue base of a few million.
Turning to earnings, the consensus was 33.8p a share before Tuesday's update. Shore has now upgraded to 37.4p and Investec to 37.8p. Even if we're generous and round up to 38p, the price-to-earnings (P/E) ratio is a sky-high 55. And with analysts widely forecasting annual earnings growth to moderate-to-sub-20% a year from 2018, I rate the stock a 'sell' on valuation grounds.
A more turbulent phase
Auto Trader(LSE: AUTO), which released its half-year results today, is a lower level growth stock than Fevertree. It reported first-half revenue up 7% and earnings up 14%, putting it on track to meet full-year forecasts of £331m revenue and 17.6p earnings per share. The shares are trading a tad lower at 350p, valuing this FTSE 250 firm at £3.38bn. So it's on a rating of just over 10 times sales and just under 20 times earnings. Meanwhile, annual earnings growth is forecast to run at about 12% for the next three years.
A dominant position as the UK's largest digital automotive marketplace, and the high margins and pricing power that come with it, mean Auto Trader is an attractive business. However, the rating is too high for me for the growth on offer and I also believe earnings may come under pressure over the next few years.
While, the company's management has expressed confidence in the outlook, the director of valuations at Glass's (the market analysis and statistical modelling specialists, who supply Auto Trader's identification, technical and specification data) has struck a more ominous note, reckoning that after the boom years, the industry is set to enter a more turbulent phase.
A softer market wouldn't be an existential crisis for Auto Trader but would likely lead to a de-rating of what is, in my view, already an elevated valuation of its shares. For these reasons, I rate the stock a 'sell'.
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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended Auto Trader and boohoo.com. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.