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Why this stock may slump 13% within 2 years

Image: Costa Coffee. Fair use.

It can be challenging to identify the difference between a sound business and a sound investment. Clearly, the two are linked, but in some cases the market can price in improved business performance, which makes the company in question a less enticing investment prospect. In other words, even a company with double-digit earnings growth may prove to be a disappointing investment if its shares are overvalued. Here’s an example of one such company which could fall 13% in the next two years.

Mixed performance

Today’s full-year results from Millennium & Copthorne (LSE: MLC) show that the company made progress in the 2016 financial year. Its revenue per available room (RevPAR) increased by 6.6%, which contributed to a 9.3% rise in total revenue. This caused reported pre-tax profit to be 0.9% lower in what was a relatively challenging year for the business. However, this was in line with expectations and as a result, the company’s share price is flat today.

However, when the impact of currency changes is removed from the results, Millennium & Copthorne’s performance was far less impressive. Its RevPAR fell by 2.3%, while total revenue was flat in constant currency terms. Furthermore, pre-tax profit moved 12.9% lower in constant currency terms. Clearly, there is scope for further declines in the value of sterling in 2017 and 2018. However, on an underlying basis, the performance of the business is somewhat disappointing.

Share price prospects

Over the last five years, Millennium & Copthorne’s shares have traded on an average price-to-earnings (P/E) ratio of 16.1. Today, it has a P/E ratio of 19.3, which indicates that a share price fall could lie ahead. Since the devaluation of sterling is expected to positively impact on its reported results, the business is due to record a rise in its bottom line of 10% in 2018.

While this has the potential to improve investor sentiment in theory, the reality is that even with the uplift in its earnings, Millennium & Copthorne’s share price could fall by around 13%. That’s because its P/E ratio may revert to the historic mean, which when applied to next year’s higher earnings equates to a share price which is around 13% lower than its current valuation.

Better option

While hotel chains across the globe are enduring a challenging period, sector peer and Premier Inn owner Whitbread (LSE: WTB) is expected to record upbeat growth over the next two years. Its earnings growth rate of 6% this year and 9% next year may only be in line with that of Millennium & Copthorne, but its valuation indicates that its shares could soar in the next couple of years.

Whitbread’s historic P/E ratio over the last five years is 19.4. However, today it has a rating of only 16.2. Assuming it will revert to its mean P/E ratio of recent years, its shares could be worth around £54 by the end of next year. This would indicate a rise of over 37% from their current level. Clearly, Brexit may hurt its outlook, but with such a wide margin of safety it seems to be a strong buy at the present time.

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Peter Stephens owns shares of Whitbread. 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.