Online fashion retailer Boohoo’s (LSE: BOO) share price has surged in recent days. After trending down from 225p to 170p between mid-June and mid-September, the stock has suddenly spiked back above 225p on high volume. At the current price, the stock trades on a forward-looking P/E ratio of 58.3 for the year ending 28 February 2019, falling to 47.1 for the following year, using current consensus estimates. Is that a price worth paying or is the high valuation a trap?
In general, I tend to stay away from highly-valued stocks. A P/E ratio in the mid-20s is one thing, but if the ratio is above 50, I’m often a little wary. The main reason for this is that if a stock has a really high P/E ratio and is ‘priced for perfection’, it doesn’t take much for the share price to fall significantly. For example, if a highly-valued stock experiences a period of slower revenue growth or announces earnings that miss expectations, its share price could easily fall 20% or more in the blink of an eye. So, it pays to be cautious with stocks that have super high valuations.
Having said that, if a company has an excellent business model and is generating outstanding growth, then a premium valuation can sometimes be justified. And when I look at Boohoo’s business model and the growth that the company is generating right now, it’s hard to ignore the investment case.
For example, for the most recent half-year period, group revenue surged 50% to £395m and the group raised its revenue growth guidance for the full year to 38% to 43%. When you consider that a number of traditional retailers (Debenhams, House of Fraser etc.) are pretty much on life support right now, that’s an outstanding performance. Even more impressive is the performance of acquired brand PrettyLittleThing, which enjoyed top-line growth of a staggering 132% and saw its number of active customers rise 99% on the same period last year. Overall, Boohoo Group’s adjusted earnings per share rose 31% to 1.99p for the period which is a strong performance and suggests that full-year earnings could beat current consensus estimates.
Winning business model
To my mind, these numbers (as well as a three-year average return on equity of 23%) indicate that Boohoo has a winning business model. The company has a very specific target market (16-30 year-olds) and is simply in the right place at the right time to capitalise on the demand for affordable, on-trend clothing from Millennials. Shopping habits have changed dramatically over the last 10 years, and Boohoo appears to be at the forefront of the revolution.
Higher-risk growth play
So, going back to the valuation, I don’t think Boohoo shares should be ruled out just because the P/E ratio is high.
Of course, at that valuation, the stock is no bargain so I wouldn’t advise betting your life savings on it. However, a small position as part of a diversified portfolio could be a good strategy, in my view. That’s how I’m playing the stock myself.
Edward Sheldon owns shares in Boohoo Group. The Motley Fool UK has recommended boohoo group. 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.