How much of a premium should you pay for shares in high quality businesses such as Reckitt Benckiser Group (LSE: RB)?
Reckitt boasts an operating margin of more than 20%, very little debt and strong free cash flow generation. In 2015, Reckitt's free cash flow was almost exactly equal to the firm's post-tax profits. That's a surprisingly rare achievement. It means that all of the firm's paper profits were actually converted into spare cash.
This strong performance probably does means that the firm's shares deserve to trade at a slight premium to the FTSE 100 average. But there must be a limit. After all, we don't just want to buy good companies. We want to buy good companies at a good price. If the price is too high, we're unlikely to make a decent return on our investment.
Reckitt's share price has risen by 90% since April 2010, but the firm's earnings per share have only risen by 13%. As a result, Reckitt shares now trade on a 2016 forecast P/E of 25 with a forecast dividend yield of just 2.1%.
I think there's a good chance that investors buying today may be disappointed at the return on their investment. In my view, now is probably not the right time to buy.
A far better choice?
On the face of it, Rolls-Royce Holdings (LSE: RR) has a similar valuation. The firm's shares trade on a 2016 forecast P/E of 26 and a prospective yield of 2.2%. But the difference is that Rolls-Royce's share price and its profits have fallen sharply over the last couple of years.
Rolls is a business that's going through a turnaround process. The group could deliver significant earnings growth over the next few years, if its efforts are successful. The City expects good progress and is forecasting a 30% rise in earnings per share in 2017, along with 9% dividend growth.
Although there's still some uncertainty about how the changes at Rolls-Royce will affect the group's profitability, I believe Rolls-Royce could be a good recovery buy.
Not as cheap as it looks
Rolls-Royce and Reckitt Benckiser both have high P/E ratings. Pharmaceutical firm Shire (LSE: SHP) is a bit different. The firm's shares seem quite affordable, trading on just 14 times 2016 earnings.
But that isn't the whole story. Shire is in the middle of a $32bn takeover of US firm Baxalta. This includes a cash element that will be funded by a new $18bn lending facility. This is a significant amount of debt for a firm like Shire, which reported a net profit of just $1.3bn last year.
The logic behind this big loan is that the combined group will be able to repay the debt quite quickly. Shire says that it expects to generate operating cash flow of $6bn per year by 2018.
However, I'd argue that until we see some evidence that the Baxalta deal will deliver the promised benefits, Shire shares carry some extra risk. Shire's dividend yield is also just 0.5%. That's not much of a compensation if the shares lag behind the market.
City analysts don't expect the Baxalta deal to have much effect on Shire's earnings until 2018. In my view, now probably isn't the best time to buy.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has recommended Reckitt Benckiser. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.