ARM (LSE: ARM), BG (LSE: BG), CRH (LSE: CRH) and Hargreaves Lansdown (LSE: HL) are all good companies. They are leaders in their respective fields, have strong balance sheets and are set to report mid-teens earnings growth over the next two years.
However, due to the high quality of these businesses, investors are paying a significant premium to get their hands on the shares.
Unfortunately, these high valuations leave little room for error and if these companies fail to meet expectations then their share prices could rapidly fall back to earth.
BG Group is a prime example of how companies with seemingly bright prospects can fall back to earth. Indeed, back in 2012 the company’s shares were worth more than £15 each as management pumped money into liquefied natural gas projects, which promised a high return.
Three years later and BG’s shares have fallen by as much as 35% as growth has failed to materialise. What’s more, the group still trades at a high growth multiple.
At present levels, BG trades at a forward P/E of 35.4, falling to 17.4 during 2016 according to current City forecasts. These two metrics are significantly above the oil & gas producers sector average P/E of 12.1. This indicates that BG’s share price could fall further still if the company fails to meet City targets.
Market darling ARM is undoubtedly one of the UK’s most successful companies. And the company’s valuation reflects that.
ARM currently trades at a forward P/E of 34.6. However, earnings growth of 69% is expected next year, as the company benefits from increasing demand for smartphones across Asia. Nevertheless, ARM’s earnings growth is expected to slow during 2016 to only 18%. So, the company is trading at a 2016 P/E of 29.3, which appears to be expensive when compared to the company’s projected growth rate for the year.
Once again, if ARM fails to live up to expectations, the company’s shares could fall rapidly back to earth.
Ireland-based building materials company CRH is a highly cyclical business — the company’s growth is highly dependent upon economic growth.
And with that in mind, CRH should trade at a low valuation, to reflect the unpredictability of the group’s business. This is not the case.
For example, CRH currently trades at a forward P/E of 20.7, falling to 16.5 for 2016. Still, according to current City forecasts, these figures look justifiable. The City expects earnings per share growth of 53% for 2015, followed by growth of 25% for 2016.
Nonetheless, there’s no telling if the current economic environment will continue. A sudden deterioration in consumer spending or collapse in construction market activity will hit CRH hard and push the company’s valuation back to earth.
Unlike ARM and CRH, fund supermarket, Hargreaves Lansdown is not set to grow rapidly over the next few years. But the group still trades at a lofty valuation of 28.7 times forward earnings.
Earnings per share are expected to grow only 1% during 2015. Growth is expected to pick up during 2016 to 15%, although the group is trading at a 2016 P/E of 25, which still seems expensive.
Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended ARM Holdings and Hargreaves Lansdown. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.