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.
- An upward P/E re-rating.
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 whether 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 (UKX), where the compound annual earnings-growth rate has been just 0.7% over the past five years:
|
Year to June |
2007 |
2008 |
2009 |
2010 |
2011 |
2012 |
|---|---|---|---|---|---|---|
| FTSE 100 index | 6,608 | 5,626 | 4,249 | 4,917 | 5,946 | 5,571 |
| 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 Smith & Nephew
|
Trading Year |
2007 |
2008 |
2009 |
2010 |
2011 |
|---|---|---|---|---|---|
| Revenue ($m) | 3,369 | 3,801 | 3,772 | 3,962 | 4,270 |
| Adjusted earnings per share | $0.52 | $0.556 | $0.656 | $0.736 | $0.745 |
So, earnings have grown at an equivalent 9.4% compound annual growth rate, putting the firm in the Stalwart category.
The company supplies joint replacements for knees, hips, and shoulders; the tools for minimally invasive surgery; advanced wound dressings; and the nuts, bolts, plates, and nails used in trauma surgery. Fifty-four percent of revenue comes from orthopedics, 24% from advanced wound management, and 22% from endoscopy. It's a business with a global reach, and Smith & Nephew employs around 11,000 in more than 90 countries.
At the last tally, the U.S. was its biggest market, providing 41% of revenues, followed by Europe, Africa, Asia, and Australasia, providing 33%, and the remaining Americas 26%. The company has been turning these revenues into strong flows of cash to the benefit of the dividend. The recent interim payout was 50% up on the year before.
It's hard to see demand for Smith & Nephew's products waning any time soon, and considering that along with the firm's industry-leading position makes me optimistic about the prospects for continuing earnings growth.
Smith & Nephew'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: Revenue and earnings have been growing; cash flow has been flat. 3/5
2. Level of debt: At the last count, there was net cash on the balance sheet. 5/5
3. Outlook and current trading: We've had good recent trading and a cautiously positive outlook. 4/5
4. Enterprise value to free cash flow: At around 18, it's above historic growth rates. 1/5
5. Price to earnings: This stands at a trailing 14 and above recent growth rates. 2/5
Overall, I score the firm 15 out of 25, which encourages me to believe this stalwart can continue earnings growth that outpaces that of the wider FTSE 100. When compared with the FTSE's price-to-earnings ratio of around 11 and the firm's growth predictions, the shares seem to price the company fully.
Foolish summary
There has been a good showing on trading and debt reduction, but valuation scores are low, with the company looking expensively priced given its growth expectations.
Right now, forecasted earnings growth is 6% for 2013, and the forward P/E ratio is about 13 with the shares at 651 pence. Considering that and the other factors I've analyzed in this article, I think the firm can stay on watch, for now.
Smith & Nephew 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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