Whats Expensive?

Identifying Overvaluation

I have been spending a lot of time looking for value, and its not easy at the moment; as I’ve outlined on numerous occasions before ultra-low interest rates have continued to force yields down and prices up across most asset classes.

Anyway this got me thinking about whether it would be useful for subscribers for me to seek to identify shares that may be overvalued; now this can be a tricky thing to do as even the most expensive shares can remain expensive for prolonged periods for no good reason other than people continue to believe the story behind the growth.

That said however we are not seeking to “short” these shares that would be risky! The objective is to consider are these shares expensive? If I hold them do I want to continue to hold them?

(With regards short positions remember if you short a share the pay off is limited to the share reaching £0 but the risk is unlimited as it can keep going upwards)

So what should we look for in a share to see if it is expensive – here is my checklist of a few key points that should be examined
  • High price to sales ratio – typically in the top 10% of the index
  • Falling liquidity ratios – such as current ratio, dividend cover, interest cover etc
  • Declining cash flow from operating income but rising earnings per share
  • Declining margins or profitability
  • Growth in long term debt
  • High levels of asset growth
  • Significant short interest
  • Director sales

So armed with these ideas I have been having a look to find some expensive shares, which I duly have and will posting on the members section shortly; however in the interim here are two that I looked at and consider expensive – remember I am not suggesting that they will fail simply that they are expensive!

Admiral Group

From the end of 2011 this share has advanced by 139% as earnings per share have grown at an enviable rate of 10% p.a. the PE ratio is not too demanding at 17.7x and the CAPE is also low at 15.9; surely this is a success story……..?

Maybe but before you do consider the following: –

  • Price to sales stands at 5.9x up from 3.9x two years ago and revenues appear much flatter
  • The current ratio was 4.2 in 2013 and is now 1.6
  • Interest cover is high 34x but last year it was 77
  • Dividend cover was 2.2 last year and is now 1.8 – it is forecast to fall below 1 by 2017
  • Fixed charge cover has fallen from 103 in 2013 to 15.6 in 2015
  • Operating cash flow recovered last year but remains below 2013 levels
  • Margins have remained fairly constant but ROA and ROE have been in decline for the last couple of years
  • Total borrowing has increased
  • Total assets have increased by 533% over the last ten years
  • The payout ratio is significantly higher than average
  • 4.93% of the companies shares are in short positions putting it in the top 25 shorted shares in the UK
  • Director sales have taken place in the last three months

Now it we put all this together would you still buy into the growth story?

Hargreaves Lansdown

Growth of over 727% from the 2009 lows despite the recent pull back in price, with growth in EPS over the last seven years of more than 20% annualised and no borrowing will have no doubt seen this share form part of many investors portfolio’s. However should it stay there? The firm has an aggressive marketing strategy and has seen it become a favourite platform for many with attractive features and a perception of offering value for money. All this may be the case but how much market share can they obtain that would result in a continuation of the level of growth that has been achieved in recent years.

Lets take a look at the same key points as we did for Admiral: –

  • Price to sales stands at 15.8x – I find it extremely difficult to justify paying this much for a share and the 3rd highest in the FTSE100
  • Cyclically Adjusted PE of 24 which is generally considered expensive
  • The current ratio was 2 in 2013 and is now 1.5
  • Interest cover is high 220x and very strong
  • Dividend cover has dipped sightly to 1.5 but still close to average
  • Fixed charge cover remains extremely healthy
  • Operating cash flow is rising
  • Net margins have fallen from to 19.3% for the trailing twelve months from over 50% in 2013
  • ROA and ROE have been in decline for the last couple of years
  • Total assets have increased by 738% over the last ten years
  • Short positions have been increased since 2015 to 1.69% of the total shares outstanding
  • Director sales have taken place in the last three months
  • The last three years have seen significant share buy backs – this is not always a good thing see my article Returning value to who?

Overall again I am unconvinced that this share will deliver significantly more value from this point


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