LONDON -- Capital appreciation is surely the goal of many investors. One method of achieving that is to buy companies with steady earnings growth. If bought when the shares are cheap, two drivers could move the share price up:
- growth in earnings, and
- an upward P/E rerating.
Highly successful fund manager Peter Lynch classified steady growers as Stalwarts, which he typically traded for 20% to 50% share-price gains. But whether buying for gains like that or holding for the longer term, we need to know if reliable earnings growth can continue, and whether the shares are cheap.
Seeking durable growth
Not all companies achieve stable growth as you can see by the aggregate performance of those in London's premier FTSE 100 (INDEX: ^FTSE) index, where the compound annual earnings-growth rate has been just 0.7% over the last five years:
|
Year to June |
2007 |
2008 |
2009 |
2010 |
2011 |
2012 |
|---|---|---|---|---|---|---|
|
FTSE 100 index |
6608 |
5626 |
4249 |
4917 |
5946 |
5571 |
|
Aggregate earnings per share |
537 |
503 |
427 |
397 |
527 |
557 |
Consistent, cash flow-backed growth in profits is a promising characteristic in today's markets so, for this series, I'm examining firms with annual earnings growth between 4% and 20%.
One contender is Next (NXT -0.11%), which is a U.K.-based retailer of fashion and accessories. This table summarizes the company's recent financial record:
|
Year to January |
2008 |
2009 |
2010 |
2011 |
2012 |
|---|---|---|---|---|---|
|
Revenue (million pounds) |
3329 |
3272 |
3407 |
3298 |
3441 |
|
Adjusted earnings per share (pence) |
168.7 |
156 |
188.5 |
217.6 |
253.9 |
So, earnings have grown at an equivalent 10.8% compound annual growth rate, putting Next in the Stalwart category.
Next last updated the market on Oct. 31, saying that full-year earnings are expected to come in up between 10 and 15%. That sounds like "steady as she goes," to me, with performance along the lines of what we've come to expect.
The Next brand was established in 1982 and has expanded steadily ever since. Now, the firm gets its range of clothing, flowers, gifts, sports gear, baby gear, and electricals out into the market via its chain of more than 500 stores in U.K. and Ireland, 200 mainly franchised stores around the world, and its home shopping catalogs and websites that serve around 50 countries.
Last year, around 64% of sales were through its Retail division, 32% through its catalog and Internet Directory division, just over 2% from its fledgling International Internet division and the rest from other sources. Growth continues apace and the company has a good record on converting sales to cash flow. That cash backs earnings, and there's no sign of forward weakness on that score.
Next's earnings growth and value score
I analyze five indicators to determine whether earnings growth can continue and if the shares offer good value:
1. Growth: Steady earnings and cash flow growth but revenue up and down. 4/5
2. Level of debt: Net debt is around last year's earnings. 4/5
3. Outlook and current trading: Good recent trading and a cautiously positive outlook. 4/5
4. Enterprise value to free cash flow: Trailing around 20, just above historic growth. 3/5
5. Price to earnings: Trailing at about 14.75, just above historic growth rates. 3/5
Overall, I score Next 18 out of 25, which encourages me to believe this stalwart can continue earnings growth that outpaces that of the wider FTSE 100, and that the shares offer reasonable value when compared to the FTSE's price-to-earnings (P/E) ratio of around 11 and the firm's growth predictions.
Foolish summary
Cash flow is strong and backs up earnings. Borrowings seem under control and the outlook is encouraging.
Right now, forecast earning growth is 10% for the year to January 2014, and the forward P/E ratio is just over 12 with the shares at 3,746 pence. Considering that and the other factors analyzed in this article, I think that looks quite attractive.
Next is one of several steady-earnings-growing stalwarts on the London stock exchange, each with the potential to deliver significant capital appreciation when purchased at sensible prices.
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