Capital appreciation is surely the goal of many investors. One method of achieving that is to buy companies with steady earnings growth. If bought when the shares are cheap, two drivers could move the share price up: growth in earnings, and an upwards P/E re-rating.
Highly successful fund manager Peter Lynch classified steady growers as stalwarts, which he typically traded for 20% to 50% share-price gains. But whether buying for gains like that or holding for the longer term, we need to know if reliable earnings growth can continue, and whether the shares are cheap.
Seeking durable growth
Not all companies achieve stable growth, as you can see by the aggregate performance of those in London's premier FTSE 100 index, where the compound annual earnings-growth rate has been just 0.7% over the last five years:
Year to June
FTSE 100 index
Aggregate earnings per share
Consistent, cash flow-backed growth in profits 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 Serco Group (ISE: SRP.L) , which is a service company serving the public and private sectors. This table summarizes the company's recent financial record:
Revenue (millions of pounds)
Diluted earnings per share
So, earnings have grown at an equivalent 20.3% compound annual growth rate putting Serco just above the Stalwart category.
Serco describes itself as a service and outsourcing company with more than 100,000 employees delivering mission-critical services to government and private clients in over 30 countries.
Its diverse operations include traffic management systems covering more than 17,500 kilometers of roads worldwide, secure computer and software support service to all 66 U.K. law enforcement agencies, managing 192,000 square miles of airspace in five countries, managing education authorities on behalf of local governments, providing defense support services worldwide, and transporting more than 275,000 passengers everyday on driverless trains on London's Docklands Light Railway.
Around 65% of revenue comes from Europe, 19% from the Americas and 16% from Africa, the Middle East and Australasia. Internationally, Serco gets over 90% of its business from public organizations, and the forward order book stands at about 19.4 billion pounds; however, the directors see a pipeline of opportunities worth around 30 billion pounds worldwide. If Serco can win some of that business, it's likely that earnings growth will continue.
Serco's earnings growth and value score
I analyze five indicators to determine whether earnings growth can continue and if the shares offer good value:
1. Growth: revenue and profits have been growing steadily; cash flow has been lumpy. 3/5
2. Level of debt: At the last count, net debt was around 2.7 times annual earnings. 3/5
3. Outlook and current trading: satisfactory recent trading and a confident outlook. 4/5
4. Enterprise value to free cash flow: around 21 and near historic growth rates. 3/5
5. Price to earnings: a trailing 16-or-so and below historic growth rates. 4/5
Overall, I score the company 17 out of 25, which encourages me to believe this stalwart can continue earnings growth that outpaces that of the wider FTSE 100. The shares seem to price the company fully when compared to the FTSE's price to earnings ratio of around 11 and the firm's growth predictions.
There's quite a chunk of debt and cash flow has been a little up-and-down, although it does support profits. As long as growth keeps generating cash, that debt doesn't look problematic. The outlook is encouraging on that front.
Right now, forecast-earning growth is 9% for 2013, and the forward P/E ratio is about 13 with the shares at 571 pence. Considering that and the other factors analyzed in this article, I think that Serco can stay on my watch list for now.
Serco Group is one of several steady-earnings-growing stalwarts on the London stock exchange, each with the potential to deliver significant capital appreciation when purchased at sensible prices.
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The article Is FTSE 100 Stalwart Serco a Good Value? originally appeared on Fool.com.
Kevin Godbold does not own any shares mentioned in this article. The Motley Fool has adisclosure policy.
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