12 Jan Why I’d ditch Rolls-Royce Holding plc to buy this high-growth dividend stock
Rolls-Royce Holding (LSE: RR) is a company with a fantastic heritage, great products and a powerful brand.
But although these are all things that I’d find attractive in a new investment, they aren’t — on their own — enough to persuade me to open my wallet. They only show part of the picture. The other part comes from the numbers: profit, cash flow and valuation.
What are you paying for?
I like to feel that I’m getting decent value for money when I buy shares. That’s not the case here.
Rolls-Royce stock currently trades on 25 times 2017 forecast earnings. This pricey rating is set to rise this year, as current broker forecasts indicate that earnings are expected to fall by 10% in 2018, giving the stock a forecast P/E of 28.
The dividend isn’t much to get excited about, either. A payout of 13.4p per share is expected in 2018, implying a forecast yield of 1.6%.
In my view, the aero engine firm’s shares are priced as if strong future growth is a certainty. And although I do believe that chief executive Warren East will be successful in his bid to return this firm to growth, I don’t think the current share price leaves much room for gains.
For example, even if earnings rocketed 50% higher in 2019, today’s share price would still be equivalent to a P/E of 18.
For me, the risk of paying too much for these shares is greater than the potential upside potential. Rolls-Royce remains one stock that I’d avoid at current levels.
I’d pay for this
I’m not against paying a full price for a growth business. One high-growth dividend stock I’d certainly consider buying is budget retailer B&M European Value Retail (LSE: BME).
The group’s shares climbed 3% this morning, after it said that sales rose by 22.7% during the third quarter.
In the UK, B&M’s business was boosted by a 3.9% increase in like-for-like sales and a 12.9% in total sales including new store openings. Meanwhile sales rose by 8.2% at the firm’s Jawoll chain in Germany.
This strong performance suggests to me that B&M stores haven’t yet reached saturation point in the UK, supporting further growth.
What could go wrong?
Today’s trading statement was impressive, but it wasn’t a big surprise. Broker consensus forecasts already indicated that sales are expected to rise by 22% during the year ending 25 March. In reality, anything less than this at Christmas might have been a disappointment.
A second risk is that today’s statement didn’t mention profit margins. The only clue we did get was that management is confident of meeting expectations for earnings before interest, tax, depreciation and amortisation (EBITDA). This suggests margins will be in line with expectations, but there is still a little wiggle room, in my view.
A fair price for growth
B&M’s earnings are expected to increase by 20% during the current year, and by a further 19% next year.
A dividend increase of 42% is expected this year, giving a forward yield of 2%. A similar increase is expected for next year.
If this performance can be maintained — which seems possible to me — then I believe today’s forecast P/E rating of 22 could offer decent value.
This stock could climb 190%
B&M has already delivered a gain of 45% since its 2015 flotation. That’s a respectable profit, but our experts believe they’ve found a dividend growth stock that could rise by as much as 190%.
The company in question is smaller than B&M but does share some of the same attractions. However, our analysts believe the stock they’ve chosen has much greater long-term growth potential.
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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.