Unilever (LSE: ULVR) and Reckitt Benckiser (LSE: RB) are two of the most sought-after stocks trading in London today.
Indeed, the two groups have outperformed the FTSE 100 by around 20% and 46% respectively over the past five years, and they now trade at a substantial premium to the wider market.
Unilever currently trades at a rolling P/E of 25.1 and Reckitt trades at a rolling P/E of 25.3. The wider FTSE 100 trades at an average P/E of 15.5.
The question is, should you avoid these two companies due to their high valuations?
An expensive bet
Due to their defensive nature, steady historic growth and cash generation, Reckitt and Unilever do deserve to trade at a premium to the wider market.
However, based on historic valuations, Unilever and Reckitt appear to be overvalued at present.
Take Unilever for example. During the past ten years, the company has traded at an average forward P/E of around 16, which isn’t overly demanding. But, over the past three years, the company’s valuation has steadily increased. Unilever now trades at a forward P/E of 21.7, a full 36% above the historic average.
Similarly, Reckitt’s valuation has been pumped up since 2013. During the past decade, the company traded at an average forward P/E of around 17. The group is now trading at a forward P/E of 24.5. That’s a full 44% above the company’s historic average.
Poor yield
With valuations at ten-year highs, Unilever and Reckitt’s dividend yields also leave a lot to be desired. At present, Reckitt and Unilever both offer a yield below the market average.
Reckitt’s yield stands at 2.2%, and the payout is covered twice by earnings per share. Unilever currently supports a dividend yield of 2.4%, and the yield is covered 2.3 times by earnings per share.
According to City analysts, Unilever’s dividend yield is set to hit 3.3% next year, although the payout cover will fall to 1.5. The wider FTSE 100 yields 3.4% on average.
Worth the premium?
So, both Unilever and Reckitt look expensive at present levels compared to their historic valuations. Moreover, there could be trouble ahead for the two companies.
You see, Unilever and Reckitt’s performance over the past few years has been driven by investors’ search for safety and yield.
As interest rates remain depressed, investors have been forced to push cash into higher yielding assets, to achieve a better return on their savings.
A lot of this cash has been ploughed into relatively safe, defensive stocks like Unilever and Reckitt. And this has been the driving force behind the two companies’ recent performance.
Coming to an end
Unfortunately, all good things come to an end.
Sooner or later, interest rates will start to move higher, and many analysts believe that when they do, defensive stocks like Unilever and Reckitt will suffer.
With that in mind, it might be sensible to avoid Unilever and Reckitt for the time being until their valuations fall back to more normal levels.
