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Three Shares With Growing Earnings And Growing Prices

Last week, we shared how some companies with growing profits could make for disappointing investment choices as investors might have overpaid for growth. Paying a high Price-Earnings (PE) multiple for a stock can set up the stage for a contraction in the multiple if the eventual growth falls short of expectations.

But, what happens in the reverse scenario – when the PE ratio of a stock starts to expand along with earnings growth? Let’s check out the business and share-price performance of three companies to find out: health-care provider Raffles Medical Group (SGX: R01), instant-beverage manufacturer Super Group (SGX: S10) and Kingsmen Creatives (SGX: 5MZ), which operates in the Meetings, Incentives, Conventions and Exhibitions industry.

Company

Share Price

LTM EPS (cents)

LTM PE Ratio

10 May 2010 10 May 2013 10 May 2010 10 May 2013 10 May 2010 10 May 2013
Raffles Medical Group $1.60 $3.30 7.5 10.8 21.2 30.6
Super Group $0.88 $4.57 7.5 14.2 11.8 32.2
Kingsmen $0.57 $0.95 7.9 8.9 7.2 10.6

The table above shows how the share price, last-12-months’ (LTM) earnings per share (EPS) and LTM PE ratios of those three companies have changed in the three years ending 10 May 2013.

We can see how the rise in the share prices of those three companies were driven by a rise in EPS and an expansion in their PE multiple. Sometimes companies can grow per-share profits at a much faster rate than what its PE multiple suggests, leading to a mismatch between reality and expectations.

When that happens, earnings growth and an expansion in the PE multiple can fuel tremendous share price growth. This is exemplified by Super Group’s performance. Its annualised EPS growth of 24% in those three years was far in excess of its starting PE ratio of 11.8.

In fact, Shelby Davis, a superb investor who grew US$50,000 in 1947 into US$900m in 1994, revelled in such opportunities. He looked for companies with low PE multiples in relation to future growth and reasoned that the combination of earnings growth and a PE expansion would make for stunning investment returns. Davis even had a name for it, calling his strategy the Davis Double Play.

While Kingsmen and Raffles Medical Group’s subsequent annualised profit growths (4% and 13% respectively) were lower than its starting PE ratio, their share prices still increased as the PEs of those two companies expanded. It might be a case of the market giving a premium to these companies based on their healthy balance sheets (both have relatively little debt, which is a sign of good financial health) and strong operating cash flows.

We can never be sure if a company’s shares would ever undergo an expansion in its PE ratio. But the bottom-line is that expansion in the PE multiple of a company’s shares can be a powerful source of return for shareholders and a good place to start would be companies with a mismatch between its current PE ratio and likely future growth rates.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares in Kingsmen Creatives.

 

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