LONDON -- Capital appreciation is surely the goal of many investors. One method of achieving that is to buy companies with steady earnings growth. If shares are bought when they're cheap, two drivers could move their price up: growth in earnings and an upward P/E rerating.
Highly successful fund manager Peter Lynch classified steady growers as "stalwarts," which he typically traded for 20% to 50% share price gains. But whether we're buying for gains like that or holding for the longer term, we need to know whether that steady earnings growth can continue and the shares are cheap.
Seeking steady growth
Not all companies achieve steady earnings growth, as you can see by the aggregate performance of those in London's premier FTSE 100 (INDEX: ^FTSE) index, where the compound annual growth rate over the last five years has been just 0.7%.
FTSE 100 Index
Steady earnings growth is a promising characteristic in today's markets, so for this series, I'm examining firms with annual earnings growth between 4% and 20%.
One contender is Capita (ISE: CPI.L) , which is an outsourcing specialist working for public and private-sector organizations. This table summarizes the company's recent financial record:
Revenue (millions of pounds)
Adjusted EPS (pence)
Earnings have grown at an equivalent 14.6% compound annual growth rate, putting Capita in the stalwart category.
Capita specializes in sorting out and running, its clients' businesses. I like to think of the process of managing an enterprise as comprising two parts: strategic decision-making and execution. The execution element is often lacking. Capita has enjoyed considerable success since its establishment in 1987, offering execution skills to organizations. Clients outsource "noncore" functions to Capita, such as administration, ICT, HR and payroll, strategic development, and business process engineering. Capita then either takes the work directly or comes into the organization to introduce better systems and processes and train the client's staff to use them.
Mainly active in the U.K., Capita reckons it's the market leader in business process outsourcing with a 23% market share. I like the way the company analyzes its revenue according to market segment. Currently, the firm derives 20% of revenue from local government, 15% from health, 13% from education, 10% from central government, 8% from insurance, 7% from life and pensions, 4% from financial services, 3% from transport, and 20% from other businesses in the private sector. Thus, well more than half of revenue comes from the public sector.
Capita pursues growth both organically and through acquisition.
Capita's earnings growth and value score
I analyze five indicators to determine whether earnings growth can continue and the shares offer good value:
Growth: Both revenue and earnings per share have been growing steadily. Score: 3/5
Level of debt: Net gearing is around 200% as of the last count. Score: 2/5
Outlook and current trading: Recent trading and the outlook are robustly positive. Score: 5/5
Enterprise value to free cash flow: It's historically high at about 40. Score: 1/5
Price to earnings: A historical 15 based on adjusted earnings per share. Score: 2/5
Overall, I score Capita 13 out of 25, which encourages me to believe this stalwart may continue earnings growth that outpaces that of the wider FTSE 100, given the positive outlook and recent trading. However, I think the shares already price in future performance, which seems apparent when compared to the FTSE's P/E ratio of around 10 and the firm's growth predictions.
Although the outlook and recent trading are both positive, Capita's cash flow has been feeling the squeeze due to demands made from working capital. This appears to be the result of tough economic conditions affecting its clients' ability to pay quickly for services received. There's also a fair bit of debt on the balance sheet due to past acquisition activity.
Right now, forecast earnings growth is 7% for 2013, and the forward P/E ratio is about 13 with the shares at 730 pence. Considering that and the other factors analyzed in this article, I think the firm is a good candidate for my watchlist.
Capita is one of several stalwarts on the London stock exchange that are steadily growing earnings, and each has the potential to deliver significant capital appreciation when purchased at a sensible price.
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The article Is FTSE 100 Stalwart Capita a Good Value? originally appeared on Fool.com.
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