One of the first things I always do when looking at a new potential investment is to consider its valuation because, generally speaking, the lower a company’s valuation, the higher its return potential. Although this is not always the case, a modest valuation gives investors a margin of safety so that if things go wrong (and the enterprise misses growth targets for the year), the subsequent sell-off is not too aggressive.
If highly-valued equities miss expectations, the resulting exodus of investors can cause the share price to crash.
With this being the case, when I look at shares in Morrisons (LSE: MRW), I’m immediately put off the business due to its high valuation.
At the time of writing, shares in the retailer are trading at a forward P/E of 17.1, which is what I would consider a premium growth multiple. Only double-digit earnings growth would justify this valuation in my opinion. However, the City is forecasting a slight decline in earnings per share for fiscal 2019.
Not only does the share price look expensive compared to its growth potential, but the stock is also dealing at a premium to peers.
Shares in Tesco, for example, are changing hands at a forward P/E of 15.7. I would argue that it deserves a premium valuation over the Morrisons share price because not only is the company significantly bigger, it is also forecast to report earnings per share growth of 27% for fiscal 2019 and 21% for fiscal 2020 eclipsing Morrisons’ meagre growth.
The one advantage the Morrisons share price does have over its larger peer is a more attractive dividend yield of 3.9%, but in my opinion, this is not enough to justify the high valuation premium.
Overall, I would avoid the Morrisons share price for the time being on valuation grounds and buy toymaker Character Group (LSE: CCT) instead.
To me, Character immediately stands out as a high-quality business. Revenue has grown at a steady rate of 10% per annum for the past six years, and operating profit has exploded from just £7.5m in 2014 to £11.7m for 2018. Return on capital employed — a measure of profit for every £1 invested in the business — hit 37% in the company’s last financial year, putting it in the top 5% of the most profitable companies listed in London.
Over the past 24 months, Character has faced some significant headwinds, such as the collapse of toys retailer Toys R Us — a major customer — and the general UK retailing environment.
Nevertheless, despite these challenges, the company has continued to push ahead. In its post-Christmas trading update, the group informed investors that products continue to sell well throughout the Christmas period and every region the business sells to is seeing growth, apart from the USA.
With this being the case, it looks as if the business is firmly on track to meet City growth forecasts for the year. Analysts have pencilled in earnings per share of 47.6p, which implies the stock is trading at a P/E of 11.3 currently.
For such a profitable company, I think this modest valuation undervalues Character. As a bonus, there is also a dividend yield of 4.7% on offer. Overall, this remarkable firm looks to me to be a much better buy than the Morrisons share price.
Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended Tesco. 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.