The valuations of some FTSE 100 companies seem to have become detached from the reality of their earnings prospects.
Ever since Vodafone sold its stake in US mobile firm Verizon Wireless last year, the market has at times fretted that the FTSE 100 group might attempt some madcap mega-acquisition, and at other times has got excited about the possibility of Vodafone being bid for at a premium price.
A case of bid excitement occurred earlier this month after the chairman of telecoms and TV group Liberty Global made some covetous comments about Vodafones assets. The market pushed Vodafones shares up to a multi-year high of over 250p, before an announcement that no bid was in the offing, and that the two companies were merely in the early stages of discussions regarding a possible exchange of selected assets.
Vodafones shares have since fallen back somewhat, but, nevertheless, remain on an eye-wateringly high valuation. After a 28% fall in earnings last year, analysts are forecasting a meagre 2% rise for the current year (ending March 2016), putting Vodafone on a price-to-earnings (P/E) ratio of 41 compared with less than 15 for the market as a whole.
Even if we look forward to Vodafones year ending March 2017 for which analysts expect earnings growth of 15% the P/E only comes down to 36. The PEG ratio (P/E divided by earnings growth) also suggests the shares are overpriced, being 2.4 on a scale where higher than 1 is considered poor value.
United Utilities and Severn Trent
The shares of FTSE 100 water firms United Utilities and Severn Trent have both made record highs this year (1,042p and 2,215p, respectively). Despite having come off the highs along with the Footsie itself the two companies still look overpriced.
A forecast 15% decline in earnings for the year ending March 2016 puts United Utilities on a P/E of 21.4, rising to 21.7 the following year with analysts expecting a further tick down in earnings. The companys P/E has been markedly lower in the past even at times when strong earnings growth was forecast rather than the current uninspiring outlook. For example, when I wrote about United Utilities in October 2013, the P/E was 15.9, and analysts were forecasting double-digit earnings growth.
Its a similar story with Severn Trent. Earnings for the year ending March 2016 are forecast to fall 19%, putting the company on a P/E of 23.8. The rating comes down a tad the following year to 23.3 with near-negligible earnings growth forecast.
Investors hunger for yield, driven by poor rates on cash and bonds, appears to have cranked up the shares and valuations of water companies. While yields of around 4% are still good compared with safer assets, the income is low relative to what United Utilities and Severn Trent have offered as an equity risk premium in the past. Furthermore, both companies have also put in place less generous dividend-growth policies for the future.
As with Vodafone, an added factor in the high rating of United Utilities and Severn Trent is probably the possibility of a takeover bid (Severn Trent rejected a 2,200p a share offer from an infrastructure fund in 2013).
However, looking at the prospects of all three companies in the absence of any bid they appear to be distinctly overpriced, with limited upside potential for the shares. I can see many more attractively-valued companies in the market companies that also have strong forecast earnings and dividend growth.
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G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.