This 4.2% yielder could have 25%+ upside over the next 2 years
Timing is clearly of great importance to investors. Buying the right company at the wrong time could lead to disappointing investment returns. Therefore, it seems prudent for investors to not only buy stocks which are performing relatively well today, but which are expected to report significantly improved performance over the medium term. As such, buying this high-yielding share ahead of improving profitability could lead to share price gains of over 25% within two years.
Today's update from the AA(LSE: AA) shows it trading in line with expectations. It has achieved an important milestone with growth in memberships, with the number of paid personal memberships at 31 January being almost 3.4m. This represents growth of 0.4% since 31 July 2016, with the AA's strategy of focusing on retaining customers as well as winning new business proving successful.
Customer numbers have been boosted by innovation, with the company's new customer relationship management system and digital channel helping to differentiate it from the competition. It has been able to introduce cost savings that have made the business more efficient, while the insurance division has also started to show progress. This is despite three successive rises in Insurance Premium Tax (IPT), which have made trading conditions challenging.
While the AA's performance has been solid, it's due to rapidly improve. In the 2017 financial year ended 31 January, it was due to record a rise in earnings of 1%. In the 2018 and 2019 financial years, the company's bottom line is forecast to rise by 12% and 15% respectively. This puts the stock on a price-to-earnings growth (PEG) ratio of 0.5, which indicates there's considerable upside. In fact, if the firm meets its forecasts in the next two years and rises by 25% in the period, its shares will have a price-to-earnings (P/E) ratio of 10.5. This would indicate they still offer excellent value for money.
The AA's outlook rivals that of fellow insurance business Prudential (LSE: PRU). It's forecast to record a rise in its bottom line of 16% this year, followed by growth of 8% next year. However, it trades on a higher PEG ratio than the AA, with Prudential's PEG being 1.3. While this indicates there's less potential upside over the medium term, Prudential's business model arguably carries lower risk than its insurance peer. It has exposure to the emerging world in particular, which provides it with a highly desirable long-term growth profile.
Of course, the AA remains a more enticing income option, since it yields 4.2% from a dividend which is covered 2.5 times by profit. This compares to Prudential's yield of 2.8%, which is covered 2.9 times by earnings. Since both stocks trade on relatively low valuations, they appear to be strong buys for the medium term, with the AA having 25% or more upside between now and 2019.
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Peter Stephens owns shares of Prudential. 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.