Is it crazy to buy these stocks trading at over 35x earnings?
Value investors may balk at the lofty valuation of Gym Group (LSE: GYM), whose shares trade at 37 times consensus forward earnings, but are the market's high expectations misplaced when it comes to this provider of low-cost gyms?
A valuation this high signifies investors are expecting significant future growth and so far Gym Group is living up to expectations. In 2016 the company added 15 new sites to increase its portfolio to 89 locations and it plans to add a further 15-20 annually in each of the next few years.
This rapid rollout is taking advantage of consumers' increasing demand for gyms and budget ones in particular. And the group's prices are certainly attractive to value-conscious shoppers with monthly fees starting at around £25. The popularity of this competitive model is clear in the 19.1% year-on-year rise in customers to 448,000 at year-end.
This huge increase in customer numbers is feeding through to the company's books as total revenue for 2016 rose 22.6% year-on-year. While the company hasn't released full-year financial results yet, we should expect an improvement on already impressive half-year EBITDA margins of 31.9% due to the benefits of increased scale.
Solid and growing margins combined with relatively low capex costs for new gyms means the company is kicking off enough cashflow to fund expansion from retained earnings. This suggests the balance sheet, which is already in good health with only £5.2m in net debt, should continue to improve in the coming quarters and allow for dividend payments to begin.
My only concern is that opening budget gyms is a business with fairly low barriers to entry. But,Gym Group so far has had little problem expanding market share and retaining customers. If the company can continue to improve margins while expanding rapidly I reckon investors wouldn't be crazy to take a closer look in 2017.
A record to toast
Shares of long-time investor favourite Fevertree Drinks (LSE: FEVR) are even more dearly priced at 56 times forward earnings. However, as the maker of premium drink mixers continues to post double-digit sales and profit growth quarter after quarter, this may not be a ridiculous valuation.
The company's latest results, a pre-close full-year trading update, disclosed that an extra strong second half was expected to lead to annual revenue jumping 73% year-on-year to £102.2m. And while sales in all regions grew by at least 39%, I was particularly glad to see sales from the UK wind up a whopping 118% higher than in 2015.
The fact that Fevertree could double sales in its biggest and most saturated market leads me to believe that the company's future in even larger markets, such as the US, is incredibly promising. Furthermore, its asset-light business model that involves outsourcing the laborious and expensive bottling and distributing work to third party vendors ensures group profitability remains very high. EBITDA margins for the first half of 2016 grew from 30% to 30.9% and should continue to improve as central expenses such as marketing reduce as a portion of overall revenue.
Fevertree certainly isn't priced for bargain hunters at around 15 times full-year sales, but the founder-led management team's proven ability to continue growing the business at a stunning rate keeps the drinks maker firmly on my watch list in 2017.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.