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Should You Buy ASOS plc On Takeover Speculation?

ASOSShares in online fashion retailer ASOS (LSE: ASC) have climbed by more than 20% this week, thanks to rumours that the firm’s biggest shareholder, Danish firm Bestseller, had been offered £50 per share by a US buyer.

Despite this week’s gains, however, ASOS shares remain down by around 55% so far this year, thanks to big slides triggered by two profit warnings.

Should you buy?

I’m pretty confident that ASOS has a bright future, in the long term. Given that the firm’s valuation has collapsed this year, could now be a good time to buy?

Maybe.

The first thing you need to remember is that at its peak of more than £70 per share, ASOS’s valuation was pretty bonkers — around 120 times 2015 forecast profits.

Markets soon got wind of the problem, when ASOS warned in March that the costs of new warehousing and IT capacity would cut operating margins to around 6.5%, from last year’s level of 7.1%.

Profit warning #2 followed in June, when the firm said that falling margins, higher promotional costs, and currency headwinds would lead to an operating margin of just 4.5% this year — less than a third of that of high-street peer Next, which reported an operating margin of 15.6% last year.

What about growth?

The ASOS growth story remains strong: the firm reported a 25% year-on-year increase in sales during the quarter to 31 May.

What we don’t yet know is how badly the firm’s profit growth will be affected by this year’s falling profit margins.

If ASOS could maintain the 30% average earnings per share growth it’s delivered over the last six years, earnings per share could rise to around 135p in just three years — equivalent to a solid P/E of around 20, at today’s share price.

For rumoured trade buyers eBay and Amazon, this could be attractive — their game is to acquire market share at wafer thin profit margins, and then gradually grow profits. On this logic, a £50 per share bid for ASOS could make sense.

However, for private investors, decent profits, preferably backed by shareholder returns, are needed to support the ASOS share price and deliver capital gains. I’m not convinced that today’s £27 share price is low enough to offer this promise.

After all, the secret to making big, low-risk profits from growth stocks is to invest when valuations are lowbefore the wider market has identified the opportunity.

A good example of this is the small, high-tech manufacturer featured in "The Motley Fool's Top Growth Stock For 2014".

This British firm serves a fast-growing niche and is increasingly profitable -- indeed, small cap expert Maynard Paton believes the company in question could deliver 'double-digit total returns' to shareholders over the next few years.

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Roland Head has no position in any shares mentioned. The Motley Fool UK owns shares of ASOS and eBay. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.