The price-to-earnings (P/E) ratio is probably the valuation measure most relied on by private investors. It’s a pretty useful one, as well as being easy to calculate, and there’s logic in the broad idea that low P/E stocks are cheap and high P/E stocks are expensive.
Today, I’m discussing why I’d buy FTSE 100 blue chip Rolls-Royce (LSE: RR) and a lesser-known FTSE 250 firm, despite both trading on relatively high P/Es.
Rolls-Royce is emerging from a few tough years, during which performance suffered from a range of issues. These included product transition challenges in the group’s Civil Aerospace division and the collapse of the oil price, which hit offshore activity and impacted on the Marine division.
During the midst of the turmoil, Warren East (previously boss of the hugely successful British tech giant ARM Holdings) joined Rolls-Royce as its new chief executive and identified the need for major changes to its management, processes and culture. His transformation plan is working and, as improving business performance has emerged, the share price has risen 35% since the start of the year.
Divergence of opinion
The company confirmed last week that its performance for 2017 remains on track. The consensus from City analysts is for earnings per share (EPS) of 34.5p, which gives a P/E of 26 at a current share price of 898p. However, the consensus masks quite a wide divergence of opinion, with 28.9p at the low end and 40.3p at the high end. If the bulls are on the mark, the P/E is 22.3 and drops to 18.5 next year on a 48.6p EPS forecast.
Broker EPS forecasts and price targets have been trending higher (even among the bearish) and with Mr East having gained a reputation for under-promising and over-delivering at ARM Holdings, I believe the current consensus P/E of 26 is likely to prove better value than it appears over the next few years. On this basis, I rate the stock a ‘buy’.
Also trading on a relatively high P/E — 23 at a share price slightly above 58p — is leading primary care property investor and developer Assura (LSE: AGR). By acquiring, extending and improving properties in this attractive non-cyclical sector, the value of the company’s assets should increase (and be reflected in a rising share price), while growing rental income should provide shareholders with nicely rising dividends.
In its half-year results today, Assura reported a £50m uplift in the value of its estate and £38m rental income, compared with £33m in the same period last year. Structured as a Real Estate Investment Trust, under which it’s obliged to distribute most of its earnings to shareholders, management’s dividend intentions for 2018 indicate a generous yield of 4.5%.
Strong growth and income prospects
Despite being the leader in the sector, Assura’s market share remains modest at around 7% and it’s seeing many opportunities in this highly fragmented market. To this end, it announced a fundraising of up to £330m, at 57p a share, alongside today’s results.
On the basis of its strong growth and income prospects in a lower-risk property sector, I’m not put off by the relatively high P/E and also rate the stock a ‘buy’.
G A Chester has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.