Ian Lance

Ian Lance

Portfolio manager

All companies, all valuations

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If you look at the metrics of the two companies below, you will notice that they are nearly identical in every aspect except for one; the share price.

Company A Company B
Sales £2,450m £2,472m
Operating profit £400m £377m
Cashflow from operations £612m £601m
Earnings per share 14.8p 14.5p
Share price 150p 490p
Price to earnings multiple 10x 33x
Dividend yield 5% 1%

Source:  Company Report and Accounts

Now, from the options below, see if you can decide why the market is valuing Company B so much higher than Company A given that, on the face of it, they appear to be very similar. Is it:

  1. Company B is expected to grow much faster in the future
  2. Company B is asset light and therefore has a higher rate of return and generates more cash than Company A
  3. Company A has a weak balance sheet
  4. A combination of all of the above

If you selected any of the options above you were wrong because this is a trick question and Company A and B are actually the same company, Rentokil, but in two different years, 2004 and 2019. Despite several management changes, the company is still exposed to the same unglamorous industries of pest control and hygiene and is still producing the same levels of sales, profits and cash that it was 15 years ago. So, what explains the fact that the share price is up by 230%?

We have an expression that “if you invest in the market long enough, you will see all companies at all valuations”, i.e. the shooting stars of today can become the dogs of tomorrow and vice versa. We have witnessed this repeatedly over the last 30 years and yet most investors still underestimate the staggering ability of the market to change its mind about a stock or sector. Rentokil is essentially the same business that it was 15 years ago and yet for some reason, the market now feels it is right to accord a multiple of 30x to its earnings where it once felt that 10x was correct. All that has really changed is sentiment towards these types of steady businesses or bond proxies which are now more highly valued because so many other asset classes, such as bonds, offer such derisory potential returns.

Despite this, investors still struggle to see a scenario in which today’s highly valued companies de-rate in the future and seem to believe their valuation multiples have moved to a new permanently high plateau. There appears to be cognitive dissonance when looking at some of today’s market darlings such as London Stock Exchange (current P/E 40x), Sage (current P/E 26x) or Diageo (current P/E 24x). The rule of ‘all companies, all valuations’ suggests this may not be a wise bet to place.

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. This article does not constitute investment advice and the information shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.

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