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Why this growth stock could slump 20%+ by 2019

With the FTSE 100 trading near to its record high, it’s unsurprising that a number of stocks are sitting on relatively high valuations. However, while some companies may justify a high rating due to strong profit growth prospects, others lack a margin of safety. Therefore, avoiding them could be the right move for long-term investors to make. Reporting today is an example of such a stock.

Respectable performance

Today’s update from Dairy Crest (LSE: DCG) is in line with expectations, with the producer of Cathedral City, Clover and Frylight expected to meet guidance for the full year. In the first nine months of the year the combined volumes of those three products, plus Country Life, were in line with the same period of last year. However, their long-term performance could improve. The company is investing in brand building and innovation, with new packaging launches and advertising campaigns having the potential to boost their sales.

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In fact, in the current year the company’s earnings are due to increase by 5%. This is expected to be followed by further growth of 8% in the next financial year and 6% the year after. While respectable, it’s roughly the same level as the wider market’s growth rate. Therefore, Dairy Crest seems to be something of a solid performer, rather than a spectacular growth play.

Valuation

The company’s growth rate would be attractive if its valuation included a wide margin of safety. However, the outlook for the UK economy is highly uncertain and consumer demand for non-essential items could come under pressure. Dairy Crest trades at a premium to its historic valuation, which indicates that its share price could fall over the medium term.

For example, the company’s current price-to-earnings (P/E) ratio is 17.3. This is higher than its average P/E ratio over the last five years of 13.8. Since its earnings are expected to grow at a similar rate to those of the wider index over the medium term, it’s difficult to justify such a high P/E ratio. If the company was to trade on its historic average, it would equate to a drop in its share price of 20%. This could take place over the next couple of years – especially if sales grow less than expected as Brexit fears hit consumer spending.

Sector peer

Of course, not all stocks within the food production space trade on premium valuations. For example, convenience food manufacturer Greencore (LSE: GNC) is expected to record a rise in its earnings of 10% in the next financial year. Trading on a P/E ratio of 15.8, its price-to-earnings growth (PEG) ratio stands at 1.6. This indicates there’s significant upside potential on offer, with a wide margin of safety protecting investors against share price falls in case earnings disappoint.

Compared to the growth rate and valuation of Dairy Crest, Greencore offers more growth and a lower price. As such, it appears to be a more prudent buy.

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