These high-flying small cap stocks could be dangerously overvalued
Investors who buy stocks based on company fundamentals are often able to ignore what's going on in the wider market. But that's not always possible.
The two companies I'm looking at today could equally be described as overvalued or as good value. Which of these descriptions you choose depends mostly on your view of the UK property market.
Both of these companies look like good businesses to me, but is now the time to buy?
A strong performer
Shares of land, property and construction group Henry Boot (LSE: BOOT) rose by 5% yesterday after the firm said 2017 profits should be "comfortably ahead" of market forecasts.
The shares have risen by 50% so far this year, lifting the group's market cap to £394m. As you'd expect, the stock is no longer obviously cheap.
Although Henry Boot's forecast P/E ratio of 12.9 may seem modest, the firm's price-to-book ratio has risen to 1.7, while the forecast dividend yield has fallen to 2.5%. These figures suggest to me that the stock is quite fully valued.
Although this valuation does seem to be supported by recent trading, my concern is that the pace of growth in this sector appears to be slowing. After rising by 24% last year, Henry Boot's earnings per share are expected to rise by about 10% in 2017, and just 3% in 2018.
Although the market for new-build houses still seems strong, recent commentary from several commercial property companies has suggested that the tail end of the market may be approaching.
I wouldn't sell shares in Henry Boot just yet. But I would keep a close eye on the market.
Incredibly high returns
Many investors believe the ultimate test of a business is its return on capital employed (ROCE). This ratio measures a company's profits relative to the capital invested in the company.
By this standard, Mortgage Advice Bureau (LSE: MAB1) is one of the best companies you'll find. This mortgage broker generated an incredible ROCE of 91.9% last year. To put this figure in context, an ROCE of more than about 15% is usually considered quite high.
The group is fairly large, with a network of about 900 advisers and a range of more than 12,000 mortgage products. Revenue has risen from £18.2m in 2011 to £92.8m in 2016. Earnings per share have risen at a compound average rate of about 50% per year over the same period.
However, these figures have to be seen in the context of the long-running housing boom we've seen in recent years.
Mortgage Advice Bureau's advantage is that its fixed costs are relatively low. Much of the pay earned by its advisers is on commission, so when mortgage sales rise, the group's profits rise quickly as well.
The downside of this situation is that if demand for mortgages does start to fall, Mortgage Advice Bureau's profits could also slide fast.
The group's stock currently trades on 19 times forecast earnings, and offers a covered dividend yield of 4.7%. If market conditions remain stable, then I think this valuation could be an attractive entry point.
For now, I'd hold. But investors will need to watch carefully for any signs that sales growth is slowing.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.