Stating that a company has a potential 90%+ upside within two years may seem somewhat optimistic. After all, history shows that the average returns from shares are in the high single-digits, rather than the high double-digits each year. However, reporting on Tuesday was a company which has strong growth potential. When combined with what appears to be a relatively low valuation, this means its share price could almost double within two years.
A transformational year
Paddy Power Betfair’s (LSE: PPB) performance in 2016 was impressive, given that it was a transformational year for the business. Its revenue increased by 18%, with double-digit growth across all of its four operating divisions. Underlying EBITDA (earnings before interest, tax, depreciation and amortisation) rose 35%, with the company’s EBITDA margin increasing to 26% from 22%. Furthermore, underlying operating profit and earnings per share were both 44% higher than the previous year.
However, perhaps of greater importance to the company’s investors was the progress made with the integration of the acquired business. That was completed sooner than anticipated and it also delivered greater efficiencies than expected. The integration of the technology platforms is on track and customers are already beginning to see the advantages of the new company’s size and scale. For example, more markets and better odds mean Paddy Power Betfair’s competitive advantage over rivals could be increased.
In 2017 and 2018, the company is expected to grow its bottom line by 22% and 14% respectively. If it meets these forecasts and its P/E rating remains at the current level of around 25, its shares could move 39% higher by 2019. However, there seems to be scope for a significant upward re-rating during the same time period. The company’s historic average P/E ratio over the last four years is 37. If it were to trade on its average rating and meet its forecasts, its shares could move as much as 90%+ higher over the medium term.
Clearly, such a high growth rate may sound improbable. However, given the progress made with the integration and the success it has brought, it may lead to a lower risk profile for the business. While investors may have sought a discount to its intrinsic value as the integration process moves ahead, if it is successfully completed then it may lead to a higher valuation.
Of course, Paddy Power Betfair is not the only gaming company that has been the subject of merger activity. Ladbrokes Coral (LSE: LCL) may also see its rating rise in future years. And since it trades on a P/E ratio of just 17.5, there seems to be significant scope for this to take place. That’s especially the case since Ladbrokes Coral is forecast to record a rise in its bottom line of 64% in 2017 and 24% in 2018. Therefore, as well as having a lower valuation than its sector peer, it also has superior growth rates.
Clearly, the gaming industry is undergoing rapid change and consolidation is a key part of the industry outlook. Size and scale advantages seem to be present with both Paddy Power Betfair and Ladbrokes Coral. While both stocks have large upside, it is the latter which seems to be the better investment opportunity, owing to its lower valuation and higher earnings growth outlook.
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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has recommended Paddy Power Betfair. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.