The Motley Fool

This dividend growth stock has 20%+ upside by 2019

Buying shares that have risen sharply after releasing results can be a risky business. After all, investor sentiment may have peaked and could be followed by a somewhat lacklustre investment performance. However, a stock which released upbeat results for 2016 on Thursday could prove to be a sound buy. Its dividend growth potential and scope for an upward re-rating could lead to high capital gains over the next two years.

Upbeat performance

Engineering company Morgan Advanced Materials (LSE: MGAM) may have recorded a 1.5% decline in 2016 revenue and a fall of 2.5% in operating profit, but its shares rose by as much as 8% following its results release. Its 2016 performance was in line with management expectations, despite trading conditions remaining challenging in the second half of the year. Its strategy implementation appears to be on track, with divestments recently announced. They should leave the business in a more streamlined state, which could improve its long-term growth outlook.

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Capital growth prospects

In the next financial year, Morgan Advanced Materials is expected to record a rise in its bottom line of 9%. This puts it on a price-to-earnings growth (PEG) ratio of just 1.4, which indicates that there is at least 20% potential upside on offer.

Furthermore, its profitability is likely to increase at an improved rate over the medium term than it has in the past, due mostly to the success of its new strategy. Therefore, it could deserve a higher rating than it has been awarded by the market in the past, with its four-year average of 13.4 being achieved during what was a period of uncertainty for the business. Although it trades on a similar price-to-earnings (P/E) ratio as its historic average, a premium rating which pushes its shares 20% or more higher may be deserved if its profitability improves.

Higher profitability should mean more rapid dividend growth. Although the company currently yields a relatively impressive 3.4%, its payout ratio stands at just 53%. This indicates that as well as capital growth potential, it could become a must-have income share.

Sector peer

In fact, the scope for a higher rating is best evidenced by focusing on one of its sector peers. Renishaw (LSE: RSW) has a P/E ratio of 27.4, which means that a 20% rise in Morgan Advanced Materials’ share price is a relatively conservative forecast. Renishaw also has a less attractive PEG ratio than its sector peer, with it standing at 1.6. But while this indicates that there is capital gain potential on offer, it may underperform its sector peer over the next couple of years.

Certainly, Renishaw’s double-digit earnings growth forecasts are hugely impressive, given the difficult outlook for the global economy. However, with a lower valuation, a yield which is 1.8% higher than its sector peer and an improving business model, Morgan Advanced Materials seems to be the better buy.

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