Profits without honour – The market’s hunt for growth can blind it to other considerations

By Kevin Murphy.

Can you name the three largest non-food retailers in the UK by market capitalisation? B&Q owner Kingfisher, Marks & Spencer and Next? Very good – now how about the fourth largest? No, it is not Home Retail Group, Dixons, Mothercare, French Connection or even Debenhams – all those big, well-established brands are still smaller than relative newcomer Asos, which has a market cap of £1.3bn.

Despite its size, the online fashion and beauty retailer is not a terribly profitable business. This year it is forecast to make £30m of profits, which puts it on a price/earning (P/E) multiple of more than 40x. There is nothing the market likes so much as growth – Asos has grown quickly and enough investors believe it will continue to do so, which is why they are willing to pay such a sky-high multiple.

By comparison, the smaller but rather better-known Debenhams is expected to make four times Asos’s profits, giving it a P/E ratio of 7x. Meanwhile Home Retail Group, which as the owner of Argos and Homebase is clearly facing some issues, is still forecast to make £73m at the nadir of a recession. Yes, only a couple of years ago the group notched up £300m in profits but today investors are being asked to pay 10 times depressed profits for Home Retail and 40 times peak profits for Asos.

None of this is to attack Asos, which is a perfectly sound business, but rather to flag up two points. The first is that, even within the retail sector, which thanks to the parlous state of the consumer’s finances is having a terrible time, there is always a company that offers the prospect of some kind of growth. As noted earlier, the stockmarket loves growth and, in the short term, price can become a secondary consideration.

More importantly, however, there is a large disparity here. The consumer is under pressure everywhere so is it likely the outlook for Asos is so much better than the one for Home Retail or Debenhams that it should be a bigger business despite significantly lower profits? Our contention, quite simply, is no.

There is always a reason for the stockmarket to buy a company such as Asos, which it sees as a very fast-growing business to be had at any price. Equally, there is always a reason not to buy a company such as Home Retail, which it sees as a poor business where profits have gone down. However, as we saw in The third dimension, history would suggest growth, and valuation are all mean-reverting.

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