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Three expensive stocks worth considering

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The price/earnings (P/E) ratio (or multiple) is a crucial figure for many investors, who see it as a ready gauge of value. The lower the P/E, which is calculated by dividing the share price (in cents) by the earnings per share (EPS), in cents – the better the value of the stock price relative to its earnings.

But this is not an exact method of assessing value.

While a high P/E ratio can certainly indicate that a stock is expensive, it can tell you that professional investors are prepared to value the company more highly because they respect the earnings growth rates the company has been able to achieve. Conversely, a low P/E ratio could be an indicator of poor performance by the company – and that the stock could be a “value trap,” where the low P/E looks attractive, but the price keeps falling.

In other words, the stock was cheap for a reason.

On the Australian market recently, a group of stocks – mostly companies with strong global businesses, and technology stocks – have been given very high P/Es by the market, because of the healthy growth expected. This can be a double-edged sword – if a high-P/E stock disappoints with its earnings or a problem appears with its business, its share price can be swiftly cut by the market.

But for a select few businesses, a relatively high P/E can be justified because of the market’s expectations for growth.

According to Thomson Reuters, the market average “historical” P/E for FY18 results is 17.5 times earnings. Some investors prefer to work with historical P/Es, which are fact; others like to use analysts’ expected earnings, in what are known as “forward” or “prospective” P/Es. These, of course, are not certain numbers, until the earnings are reported.

Note: You can find P/E and forward P/E information on nabtrade. Log in, enter the company code and refer to the ‘Earnings’ column underneath the share price chart.

Thomson Reuters puts the current market average for FY20 expected P/E at 13.5 times earnings.

Those P/Es are the starting points for seeing how far an individual stock’s valuation departs from the norm: for stocks trading at higher P/Es, the crucial point is the extent to which investors can feel confident that paying a higher multiple will be worthwhile. Sometimes this confidence comes from a proven long-term track record of meeting expectations; sometimes it comes from a belief that the company’s future market opportunity justifies the premium P/E.

Here are three situations where a relatively high P/E is potentially justified.

1. CSL (CSL:ASX)

  • Market capitalisation: $89.4 billion
  • Historical: 38.1 times FY18
  • FN Arena FY20: 29.7 times
  • Thomson Reuters FY20: 29.3 times
  • FY20 dividend yield: 1.5% (unfranked)
  • FN Arena analysts’ consensus target price: $206.53
  • Thomson Reuters analysts’ consensus target price: $210.20

There have been a few periods since CSL listed in June 1994 at the equivalent of 77 cents when buying it at a high P/E was a mistake – but not many, if you’re talking long-term investment. The Australian biotech giant has suffered the occasional share price downturn – most recently, it lost nearly one-quarter of its value in late 2018 – but the company is a true global leader, the world’s largest maker of plasma-based therapies, and a major player in vaccines, and one of a handful of stocks that has a track record of rewarding investors who buy it and watch it go higher.

That doesn’t happen by accident – CSL almost routinely under-promises and over-delivers in terms of earnings. The quality of its franchise, balance sheet strength, outstanding track record of management and confidence in future earnings growth have justified a high P/E multiple through its listed life.

CSL often suffers because it delivers great numbers, but this was expected: this was the case in February, when the company reported its half-year (December 2018) result. CSL confirmed that its full-year FY19 guidance would be at the upper end of the previously stated $US1.88 billion–$US1.95 billion range – compared to US$1.73 billion in 2018 – but the market did not view that as good enough: it was hoping for a lift in guidance.

According to Thomson Reuters’ collation of forecasts, analysts expect earnings growth of as high as 17% for CSL this year (FY19), easing to 13% in FY20, placing the stock on a P/E of about 29–30 times expected FY20 earnings.

The historical (FY18) P/E is 38 times earnings: over time CSL has traded at an average historical P/E of about 27 times earnings. The stock is not cheap, but there are plenty of professional investors who will look at the company’s potential for growth, and think that is a price worth paying for CSL. Put it this way: of the eight brokers that FN Arena polls for its analysts’ consensus, none is a seller of CSL.

 

2. Appen (APX:ASX)

  • Market capitalisation: $2.9 billion
  • Historical P/E: 59.7 times FY18
  • FN Arena FY20 P/E: 37.5 times
  • Thomson Reuters FY20 P/E: 39.4 times
  • FY20 dividend yield: 0.5%, 86.5% franked
  • FN Arena analysts’ consensus target price: $26.02
  • Thomson Reuters analysts’ consensus target price: $23.88

Technology stock Appen is a global leader in the development of high-quality datasets for machine learning and artificial intelligence (AI), with a unique business model of having a cloud-linked crowd of one million “independent agents” researching, evaluating and annotating data, advancing the capabilities of machine learning and AI algorithms. Appen’s crowd takes in data from multiple sources, including speech, text and video across multiple languages – it covers more than 180 languages and dialects – and analyses and annotates it. These highly tech-savvy people are working from wherever they want, around the globe, crunching data for Appen’s customers, customers – which include the world’s leading technology companies, automakers and governments – who use it to improve their use of AI, and for generating high-quality training data.

AI training data is a huge potential market around the world. At present, the vast majority of Appen’s revenue is generated in the US, but it is expanding into China.

In March this year, Appen bought one of its major US-based rivals, a company called Figure Eight Technologies, in a deal that enhances its global scale. The stock market was surprised and impressed by the deal, which is highly complementary in terms of what it adds to the business.

APX has been a market darling since it listed in January 2015 at 50 cents a share. The rise to $23.86 equates to almost a 50-bagger, and for the last three years, according to Stock Doctor, the total return (share price growth plus dividends) has pounded along at 132% a year (121% if we’re just looking at the last 12 months).

Do the earnings justify that? In FY18 (the calendar year) Appen more than doubled its revenue, to $364.3 million, with underlying net profit up by 148% to $49 million. The full-year dividend of 8 cents a share (86.5% franked) was one-third higher than in 2017.

From now, Figure Eight will start to contribute. Appen says it will deliver positive underlying EBITDA contribution by the second half of FY20.

The Thomson Reuters’ analysts’ consensus has APX priced at 39.4 times expected FY20 earnings, while FN Arena has the stock at 37.5 times expected FY20 earnings. Those are hefty multiples, but investors see the track record of revenue growth, high margins, and long-standing relationships with major customers as justifying the high rating.

 

3. ResMed (RMD:ASX)

  • Market capitalisation: $22.9 billion
  • Historical P/E: 31 times FY18
  • FN Arena FY20 P/E: 29 times
  • Thomson Reuters FY20 P/E: 29 times
  • FY20 dividend yield: 1.4%, unfranked
  • FN Arena analysts’ consensus target price: $16.45
  • Thomson Reuters analysts’ consensus target price: $16.99

Sleep-breathing device maker ResMed is another of Australia’s global leaders, with its core business in devices that help people suffering from obstructive sleep apnoea (OSA), chronic obstructive pulmonary disease (COPD) and other respiratory conditions to sleep better. ResMed’s crucial advantage is its continuous positive airway pressure (CPAP) machines and masks, which give it a strong market position, being considered the industry standard for moderate to severe cases of OSA. ResMed’s market position gives it pricing power and negotiating with suppliers – but sleep breathing disorders is a competitive business, with three big global rivals always snapping at ResMed’s heels, with similar products. Technological upgrades do not stay unmatched for long in this space.

The US-based company is looking to differentiate itself by developing an interesting data play: it has collected four billion nights of medical sleep data from people using its devices, and has been analysing it to help its devices “learn” their owners’ idiosyncrasies. Over 1.8 million sleep apnoea patients have signed up for ResMed’s myAir app, giving the company permission to analyse their sleep data so they can receive personalised coaching tips on how to get a better night's sleep. Res Med says this big-data approach helps it help its users stay out of hospital and have better quality of life.

Earlier this month, ResMed surprised the market with its third-quarter update, which featured a 15% surge in sales and a gross margin of 59.3%, much better than most brokers had pencilled in. The revenue figure implied that ResMed is maintaining a quarterly average 12-month rolling revenue growth figure of about 10%, again better than analysts had anticipated.

RMD has been a consistent performer, with a five-year total return of 26.4% a year, and 28.4% a year over three years. However, the stock is not a yield play, with an unfranked dividend yield forecast at 1.4% in FY20.

On present foreign exchange rates (RMD reports in US$), FN Arena sees RMD trading at 31 times FY19 (June 30) earnings and 29 times FY20 earnings. On Stock Doctor, Thomson Reuters’ consensus is very similar. Analysts polled by Thomson Reuters have a price target on RMD of $16.99: FN Arena’s consensus price target is a touch lower, at $16.45, with the most bullish broker (Morgan’s) nominating $17.34.

James Dunn is a regular finance commentator on Australian radio and television. This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531). All prices and analysis at 13 May 2019. This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.