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Why this overvalued stock is set to underperform the FTSE 100 in the next 2 years

The FTSE 100 has enjoyed a prosperous year which has seen its value rise by 19%. As such, it is perhaps unsurprising that there are a number of stocks which trade on relatively high valuations. In some cases, they are deserved. If they are able to record further rapid rises in profitability then a generous rating may continue to be applied by the market. However, in other cases, falling earnings growth may signal a downgrade in valuation. Here’s an example of the latter, with this company likely to underperform the FTSE 100 over the medium term.

Upbeat performance

The company being discussed is support services business Bunzl (LSE: BNZL). It has reported strong performance in 2016, with its revenue rising by 14% on a reported basis, and by 4% on a constant currency basis. Its operating margin increase of 10 basis points meant that adjusted operating profit was able to creep 5% higher at constant exchange rates, while adjusted earnings were 6% higher on a constant currency basis.

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Clearly, its acquisition strategy has worked well in 2016. It has a committed acquisition spend of £184m and its track record of integrating newly-acquired companies is highly impressive. Its performance in Continental Europe was strong in 2016, with it delivering revenue growth of 10% at constant exchange rates. This exposure to non-UK markets should mean that Bunzl continues to benefit from weak sterling in 2017 and beyond.

Outlook

While Bunzl has performed well and is a financially sound business, its outlook is somewhat lacklustre. For example, in 2017 it is forecast to record a rise in earnings of 3%, followed by further growth of 4% in 2018. These growth rates are lower than the FTSE 100’s expected growth in the same time period, and mean that the company may struggle to maintain its premium valuation.

The stock currently trades on a price-to-earnings (P/E) ratio of 20.8, which is relatively high when compared to the wider index. It is also higher than its historic average, with Bunzl’s shares having traded on an average rating of 18.6 in the last five years. Even if it meets its forecast in the next two years, a derating of its shares could mean that it underperforms the wider index.

Growth potential

Of course, a high P/E ratio in itself is not necessarily bad news. Provided the company in question can increase its bottom line at a rapid rate, high ratings can be deserved. Within the support services sector, Rentokil (LSE: RTO) trades on a P/E ratio of 21.7, but is forecast to record a rise in its bottom line of 10% this year and 8% the year after. This rate of growth makes it far easier to justify such a high P/E ratio, and means there is upside potential on offer.

Certainly, Bunzl has a more stable track record and a stronger business model than Rentokil. But with the former seemingly overvalued when compared to its historic valuation and to its sector peer, Rentokil seems to be the stronger buy at the present time.

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

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