Buying shares in bad businesses may be the most obvious way to lose money in the stock market.
But there’s another way of losing money that’s almost as dangerous and is often overlooked. I’m talking about valuation. Paying too much for a stock can leave you sitting on a loss for years, while the wider market steams ahead.
The two companies I’m looking at today are good businesses, but they look too expensive to me.
FTSE 100 pharmaceutical firm AstraZeneca (LSE: AZN) may seem an unlikely choice for this article. Surely this company is conservatively valued, produces reliable profits and pays a generous dividend?
Unfortunately, this isn’t the case. AZN shares have risen by 47% over the last five years to an all-time high of more than £63, despite falling profits and rising debt.
This has left the group trading on 22.2 times 2019 forecast adjusted earnings, with a dividend yield of 3.5% — well below the FTSE 100 average of 4.3%.
In my view, this valuation is pricing in a lot of future progress. I’m also concerned that the company’s preferred measure of adjusted earnings may be flattering its performance, something my colleague G A Chester covered recently in more detail.
Worse than it looks?
Over the last four years, AstraZeneca’s net debt has risen from $7.8bn to $16.3bn. I believe one reason for this is the maintenance of the group’s $2.80 per share dividend.
You see, the company has paid out about $14bn in cash distributions to shareholders since 2015, but has only reported shareholder profits of $11.5bn.
These numbers tell me that Astra is relying heavily on borrowed cash to fund investments in new medicines, while paying out all of its profits (and more) to shareholders.
The situation reached a new low in March, when Astra decided to raise $3.5bn from shareholders just days after paying a dividend of $2.4bn. This seems ludicrous to me — if cash really is that tight, the dividend should be cut.
My verdict: AstraZeneca has an exciting pipeline of new products, but I think the price is far too high, given the group’s weak cash generation and steep valuation. I’d wait for a better opportunity to buy.
Down 13% as spending climbs
My next stock also operates in the pharmaceutical sector, producing antibodies for research labs. Shares in Abcam (LSE: ABC) have risen from about 140p to 1,221p over the last 10 years, valuing this business at over £2.5bn.
However, the stock is down by more than 14% at the time of writing. Today’s fall came after the company announced plans to increase spending on expansion and said its chief financial officer had resigned.
I should explain that Abcam has delivered high profit margins and strong growth for some years. Profits doubled between 2013 and 2018, for example.
However, earnings per share for the year that ended on 30 June are expected to be broadly unchanged from the previous year. Looking ahead, analysts expect modest earnings growth of 7% for the current year.
With spending rising, it’s not clear to me whether Abcam will be able to maintain its historic operating profit margin of nearly 30%. This risk — plus slower growth — suggests to me that the stock’s forecast price/earnings ratio of 35 is rather high.
As with AstraZeneca, I think this is a good business, but in my view it’s too expensive at the moment.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Abcam and AstraZeneca. 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.