Diploma PLC is a highly successful group of businesses operating in three distinct areas: Life sciences, seals and controls. What makes this FTSE 250 listed company interesting is its policy of boosting organic growth with carefully selected and nurtured acquisitions. In the past decade the company has grown rapidly, but can that continue, and are its shares worth their 700p price tag?
Diploma began life in 1931 and moved onto its current acquisition-based strategy in 1969. However, as the decades passed the original acquisitions gradually went from growth, to maturity, and eventually into decline.
Around the turn of the millennium Diploma radically re-structured itself by selling off ten of its existing businesses. The resulting cash was then used to acquire a range of new businesses from internationally and industrially diverse backgrounds.
These businesses were successful and capable of further growth given the right investment and support.
This remains the company’s core strategy today; growing existing group businesses at ‘GDP plus’ rates, while boosting returns with new acquisitions that can benefit from being part of a group.
The businesses are run as separate business units in a decentralised fashion to enable them to react to their individual markets more effectively. At the same time they benefit from investment, systems, purchasing power, expertise and other features that the group can offer to each business.
The chart below shows Diploma’s financial results for the past few years.
A very successful business
The average growth rate is a very impressive 15% per year. That’s way above the 4% a year that UK listed companies have achieved overall.
The growth is also impressively consistent, and is in fact more consistent than the results which underpin the FTSE 100.
The only downward blip is during the financial crisis, which is no great surprise. However it only affected earnings, while revenues and dividend payments have continued to march on to ever higher highs.
In many ways this is all part of the company’s strategy, which is to sell consumable products which are bought by their customers over and over again.
The website and annual reports make a point of stating that these products are typically paid out of their customers’ operational budgets rather than capital budgets. That means purchases are less affected by the ups and downs of the business cycle, and that’s exactly what shows up in the chart of financial results above.
Low levels of debt
It’s no good having a highly successful, rapidly growing business if it goes bust at the first sign of difficult because of excessive financial obligations.
However, that’s unlikely to be a fate that befalls Diploma as it has very little debt. The company has more cash on its balance sheet than it does interest bearing debts, and so it has a net cash position which is almost always a good thing.
It also has a small defined benefit pension obligation of just £16m, which is far less than a single year’s profit.
But is the price right?
Diploma is definitely a company that I would consider buying. It’s growing quickly and consistently, it has low levels of debt and is well diversified. But no company is worth an infinite price, so how do the shares stack up from a “value for money” point of view?
A pricey PE ratio
The current PE is just over 23, but this is a growth stock and so to some extent a higher price is expected. However, I never use the standard PE for valuation purposes because it’s too volatile; earnings go up and down one year to the next, so comparing price to those volatile earnings gives too ‘noisy’ a result.
Using PE10 instead (price to 10 year average earnings) the ratio is 47.3. That’s high, even given this company’s growth history and possible future growth.
If I use my stock screen to look at other companies with a long history of consistent dividends payments and growth around 15% a year, I can see that Diploma is the most expensive, measured by PE10.
If I look at the absolute “best of the best” companies that have grown revenues, profits and dividends in every year for a decade, then they are still cheaper than Diploma, with an average PE10 of ‘just’ 36. Those companies also have an average growth rate of 17% which is more than Diploma has managed, so they are growing faster, more consistently, and yet on average are cheaper than Diploma.
So I think there’s little doubt that Diploma is expensive. In fact, a share price chart from Google Finance bears this out.
The shares were ticking along pre-crisis, fell along with everything else in 2008 and the wham! The shares shot up from about 100p in 2009 to 700p today.
100p was a fantastically good value for money price; 700p looks distinctly less so.
Look elsewhere for a high dividend yield
As a consequence of that high price the dividend yield is anything but high. The yield stands at just 2.1%, some 40% lower than the yield on the FTSE 100. But of course this is a fast and consistently growing, high quality company, so the yield probably should be lower.
But again, even among its peers of companies with similarly consistent growth, Diploma has a low yield. According to my defensive value screen, companies that are just as consistent have an average yield of 2.6%, which is what I’d expect. The average yield is low because future dividends are likely to grow faster than average, but Diploma is once again towards the bottom of the list.
Quality at an unreasonable price
Diploma is almost definitely a company that I would buy at the right price. I like companies that can grow both quickly and consistently, and pay out a progressive dividend at the same time. Who wouldn’t want that?
But the risks that come from Diploma’s current price tag of 700p per share are too great for me. I think the shares could easily fall to 500p, and even at that level I would not call them especially cheap.
If I were to use a watch list, which I don’t, I would put the price tag at something around 450p for now and review it in a year. At that price it could well be an explosive combination of quality, defensiveness and value for money.