Can Pearson's growth continue and are the shares cheap?
Capital appreciation is surely the goal of many investors. One method of achieving that is to buy companies with steady earnings growth. If bought when the shares are cheap, two drivers could move the share price up:
- growth in earnings, and
- an upwards P/E re-rating.
Highly successful fund manager Peter Lynch classified steady growers as Stalwarts, which he typically traded for 20% to 50% share-price gains. But whether buying for gains like that or holding for the longer term, we need to know if that steady earnings growth can continue, and whether the shares are cheap.
Seeking steady growth
Not all companies achieve steady earnings growth as you can see by the aggregate performance of those in London's premier FTSE 100 index (UKX), where the compound annual growth rate over the last five years has been just 0.7%:
| Year to June | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
| FTSE 100 index | 6608 | 5626 | 4249 | 4917 | 5946 | 5571 |
| Aggregate earnings per share | 537 | 503 | 427 | 397 | 527 | 557 |
Steady earnings growth is a promising characteristic in today's markets, so in this series I'm examining firms with annual earnings growth between 4% and 20%.
One contender is Pearson (LSE: PSON), which earns its living as an international publisher and is well known for its Penguin and Financial Times brands. This table summarises the company's recent financial record:
| Trading year | 2007 | 2008 | 2009 | 2010 | 2011 |
| Revenue (£m) | 4,162 | 4,811 | 5,140 | 5,663 | 5,862 |
| Adjusted earnings per share | 39p | 57.7p | 65.4p | 77.5p | 86.5p |
So, earnings have grown at an equivalent 22% compound annual growth rate putting the firm just above the Stalwart category but close enough to warrant consideration.
Pearson likes to describe itself as "the world's leading education company". It derives around 75% of overall sales from its Education sector. Within that sector, its most important market is the US, accounting for around 44% of overall company sales. The firm supplies curriculum materials, multimedia learning tools and testing programs across the educational spectrum.
In the recent full-year results statement, the company said, "In North America, we anticipate modest growth in higher education as rapid take-up of our technology and services is partially offset by lower college enrolments and challenging conditions in the market for printed textbooks."
The Penguin sector, which produces quality novels and classics, through to cookbooks and other publications around the world, accounts for around 18% of sales. The Financial times sector delivers just 7% of sales.
The firm's statements and promotional materials suggest the directors see the future of the business revolving around education.
Pearson's earnings growth and value score
I analyse five indicators to determine whether earnings growth can continue and if the shares offer good value:
1. Growth: revenue, earnings per share and net cash from operations all growing. 5/5
2. Level of debt: at the last count, net gearing was around 11%. 4/5
3. Outlook and current trading: 'inline' with a cautiously optimistic outlook. 4/5
4. Enterprise value to free cash flow: around 14 compares well to past growth rates. 4/5
5. Price to earnings: about 14 for adjusted earnings compares well to past growth rates. 4/5
Overall, I score Pearson 21 out of 25, which encourages me to believe this Stalwart can continue earnings growth that out-paces the wider FTSE 100, but the shares look generously priced compared to the FTSE's price to earnings ratio of around 10 and predicted future earnings growth rates.
Foolish Summary
Pearson's cautiously positive outlook and recent good trading is encouraging. Debt seems to be modest and cash flow supports profits. There is an impressive record of recent growth but forward predictions are less robust.
Right now, forecast earnings growth is 8% for 2013, and the forward P/E ratio is around 13 with the shares at 1230p. Considering that, and the other factors analysed in this article, I think the firm is a good candidate for my watch list.
Pearson is one of several steady-earnings-growing stalwarts on the London stock exchange, each with the potential to deliver significant capital appreciation when purchased at sensible prices.
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> Kevin does not own any shares mentioned in this article.
