Are Next shares a good investment?

Next plc has done a seriously impressive job for shareholders over the last decade.  The company has increased sales, earnings and dividends consistently through the recession.  The share price has gone from just over 700p in 2002 to more than 3,500p today.  That’s a gain of around 400%, without counting dividends.

What’s most impressive, I think, is that the company sells clothing on the high street, which is a very difficult business.

Here’s a chart which gives a slightly clearer idea of what the company has managed to do.

Next results

Everything is up over 100% in this period, and the progress is smooth and steady.  That’s exactly what I like to see, but whether or not Next’s shares are a good investment comes down to two questions:

Is Next an above-average company?

For me, the question of whether a company is good or not comes down to two factors.  The first is the company’s ability to generate earnings and dividend growth, both how much and how consistently.  The second is how much debt the company uses to fuel that growth.

So how fast is Next growing?

It has grown sales, earnings and dividends over the last decade at around 9% a year – which is far better than the FTSE 100’s rate of around 4-5% a year.

But what about consistency?  The more consistently a company can produce growth, the more likely it is that the growth will continue into the future.  It’s not guaranteed, but then nothing in equities is.

Those smooth lines in the chart above show that Next has a 90% hit rate when it comes to being profitable, paying a dividend, and growing sales, earnings and dividends each year.  That’s also better than the FTSE 100, which has a hit rate nearer 80%.

In terms of debt, the company seems to have a reasonable level of borrowings at some £600 million.  This is only slightly more than the profits that the company generates, and with interest payments covered 21 times over, the debt burden is quite small.

So at first glance, it seems that Next is a highly consistent, high-growth company that has produced those results with little debt.  It has both more consistency (which I also call growth ‘quality’) and a higher growth rate than the market.  Since it is the market we are trying to beat, investing in a company with higher growth and more consistency seems like a good idea.  It definitely gets a tick in the ‘above average’ box from me.

Are Next shares trading at a below-average price?

It’s one thing to find a good company, but no matter how good, no company is worth an infinite price.  The real money in investing is made by buying above-average businesses at below-average prices, so how can we measure that?

One way is to measure the price of an above-average business against its historical earnings and dividends.

Buying a business with a low PE and a high yield has two advantages.  The first is that the low PE means that there is more chance of PE expansion from a rising share price, and the second is that dividend income is an important part of equity returns, and a higher yield usually results in more income.

However, looking at current earnings and dividends can be misleading as they can be volatile in the short term, so I prefer to compare the share price against the last decade’s earnings and dividend payments.  I think this gives a much better approximation of price to ‘intrinsic value’ than the usual PE and dividend yield measures.

So for Next shares, the price of £36.97 is 22.5 times the average earnings of the last decade and 65 times the average dividend.  The current dividend yield is 2.4%.

In comparison, the FTSE 100 at 5,900 is priced at 13.7 times its average earnings of the last decade and 33.7 times the average dividend.  Its current yield is around 3.5%.

Next has both a higher price relative to earnings and a higher price relative to dividends than the market average.  On top of that, the current dividend yield is also lower than the market’s.

With Next’s shares at £36.97 and the FTSE 100 at 5,900, the shares of Next are unlikely to be trading at a below-average price, which means they may not be the best place to invest at the moment.

Of course, some people might argue that with such a consistently high rate of growth and such a bright future, Next deserves to trade at a premium to the market.  And they might be right.

But I also know there are many other companies out there that have records of consistent growth which are equally as impressive, but which can be bought today at a discount to the market rather than a premium.

Are Next shares a buy, hold or sell?

I like my investments to tick three of the four boxes of having better long-term growth, more growth quality (consistency), a higher yield and a lower long-term PE.  The first two measure the quality of the business, and the second two measure the value of the shares at their current price.

Next only ticks the first two, which shows that it is probably a high-quality business, but its shares fail on both measures of value.

Next also ranks as the 94th most attractive share in my investment newsletter’s stock screen, whereas the FTSE 100 comes in 74th out of about 150 dividend-paying medium and large-cap investments.

This means that if Next were part of my model portfolio, then it would be at the top of the sell list.

However, if the shares fell below £25, then I’d be interested, but not at a penny more.  That may seem like an unrealistic price, but you only have to go back to late 2011 to find the shares trading at that level.

And even if they never touch £25 again, I know there are always plenty more fish in the sea.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

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