While buying growth stocks can be a successful means of generating impressive returns in the long run, in many cases high valuations reduce the scope for capital gains. In other words, a stock with strong growth prospects often has a valuation that takes into account its bright future. As such, its margin of safety is narrow, which may lead to disappointing returns.
A prime example of such a company could be beverages stock Fevertree(LSE: FEVR). The company released a positive trading update on Wednesday, but does not appear to have an enticing outlook as an investment.
Fevertree's performance in 2017 was especially strong in the UK. It was able to make further inroads in terms of market share and now occupies the number one position within the mixer category by value in the off-trade channel. Sales in 2017 in the UK were almost double those in 2016, and the business looks set to benefit from increasing consumer demand for premium mixers.
Growth outside of the UK was also strong, with a rise in sales of 39% recorded in the US, 42% delivered in Europe (excluding UK), while sales in the rest of the world were up 57%. This took the company's total sales growth to 66% for the year, which means that its outcome for the full year is expected to be comfortably ahead of market expectations. As such, the stock increased in value by around 3% following its results. This takes its share price gain to 100% in the last year.
Looking ahead, Fevertree is expected to report a rise in its bottom line of 8% in the current year, followed by further growth of 15% next year. This is clearly an impressive rate of growth and shows that the company continues to benefit from favourable trends within the beverages industry.
However, with a price-to-earnings (P/E) ratio of 62, it seems to be grossly overvalued. In fact, its price-to-earnings growth (PEG) ratio stands at over 4, which suggests that it lacks significant upside potential. While the company may be able to beat expectations in 2018 and 2019, it seems as though investors have already priced-in financial performance that may prove to be unachievable over the medium term.
Also operating within the beverages sector is AG Barr (LSE: BAG). The company hit the headlines recently when it announced plans to reduce the sugar content of Scotland's biggest-selling soft drink, Irn-Bru. This is to avoid the government's new sugar tax, but caused some controversy as a number of previously happy customers were not particularly positive about the change and their reactions generated plenty of newspaper headlines.
As with Fevertree, Barr trades on what appears to be a high valuation. It has a P/E ratio of 20.3 and yet is forecast to post a rise in earnings of 7% this year and 8% next year. While its business seems to have a more positive outlook after a challenging period for the UK drinks marketplace, its valuation could come under pressure unless it can generate improved performance in future years. As such, now could be the time to avoid it and look elsewhere for high returns over the long run.
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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has recommended AG Barr. 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.