SKY(LSE: SKY) andBT(LSE: BT-A) have recently become FTSE 100 darlings. Investors have clamoured to get their hands on the shares of the two companies during the past 12months and as a result of this stampede, valuations have been pushed to historic highs.
For example, since August last year, BTs shares have jumped 23%, and Skys shares have risen 28% excluding dividends. Over the sameperiod,the FTSE 100 has only added a lacklustre 2.2% excluding dividends.
But BT and Skys outperformance hashad little to do with business performance. According to Cityfigures,BTs earnings per share are set to fall 3% this year. That said, analysts believe Skys earnings per share are on track to grow by 14% during 2015.
Nevertheless, over the past year BT and Skys valuationshave exploded, and its nowdebatable whether the companies deserve theirlofty valuations.
In particular, BT currently trades at a forward P/E of 15, its highest valuation since the dot-com bubble. Similarly, Sky trades at a forward P/E of 18, a multiple not seen since 2007.
However, these valuations dont necessarily mean that investors should avoid the two companies.
Crunching numbers
The stock market is just like any other marketunless theres a big sale going on, you will have to pay a premium to buy a quality product.
BT and Sky are two premium products. In fact, you say that they are the most exclusive product in their category.
Skys recent deal to merge with its European counterparts has made it one the largest pay-tv providers in Europewhile BT is the biggest telecoms company in the UK.
And Skys premium valuation is justifiable in several other ways as well. The company has been able to achieve staggering returns for investors over the past five years. Group return on equity (profit earned in comparison to totalshareholder equity) was 64% lastyear and has averaged around 80% since 2010. Whats more, last year the company generated 100p per share in free cash flow.
These impressive performance metrics have helped Sky increase shareholder equity at a compound annual rate of 41% since 2010. Book value per share over the period has risen from 32pto 184p as reported at the end of last year. There are not many other companies out there that have been able to achieve this rate of growth. Since 2009 Skys shares have outperformed the FTSE 100 by 125%.
BTs returns have been more muted, and theres a dark cloud hanging over the company in the form of a multi-billion pound pension deficit. Moreover, the companys market dominance in the UK is currently being investigated by regulators. If regulators decide to break BT up, the company will lose one of its most impressive qualities; size. As a result, it would become harder to justify BTs lofty valuation.
So overall, Skys high valuation can be justified but BT looks overvalued at present.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Sky. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.