Two Questions to Ask Before Investing in the Next Vocus

Yesterday, investors beat down Vocus Group Ltd [ASX:VOC] after the company downgraded their earnings. The stock fell to a low of $2.35, down 29.7%. After such a fall, you’d expect bargain buyers to come in and assess the situation.

Vocus’ story, until early 2016, was one of growth and prosperity. The stock reached a high of $9.40 per share.

Up until that point, revenue had climbed dramatically, by 1,741% from 2012–2016. And earnings before interest and tax (EBIT) was up 1,143.9% over the same period.

According to the Australian Financial Review, Vocus had a plan to get to a $10 billion market cap by 2021:

A few scoffed at the target but it was one of the fastest-growing telecommunication companies in Australia, so why not?

In May 2016, the market cap of Vocus did reach $5.8 billion.

After the fall yesterday, Vocus is now $8.5 billion short of realising their dream.

However, even after the profit downgrade, Vocus CEO Geoff Horth was not too worried. Maybe it’s because he needs to show shareholders everything is under control. Or maybe it’s because investors overreacted to a downgrade caused by accounting technicalities.

As reported by the AFR:

Mr Horth said more than half the earnings downgrade was from a “reclassification of revenues” from contracts written this year and revenue being realised later.

We’re very disappointed and we’re very determined to set it right,’ Horth said.

‘[I’m] absolutely confident we’re building the right team. We’re in the process of recruiting a new CTO, we recently appointed Mick Simmons to run the enterprise and wholesale business and that’s a big part in making sure that we’ve got the talent in the business and those people are able to scale with the business.

With that, let’s move on to the two questions you need to ask before investing in the next Vocus.

Is the trend really your friend?

You’ve heard of Benjamin Graham, right? He’s the one that set Warren Buffett on the path to greatness. Graham wrote a lot of books. Two of his most famous books were Security Analysis and Intelligent Investor.

But one of his lesser-known books is The Interpretation of Financial Statements. In this short book about how to read financial statements, Graham spends a little over a page talking about trends.

As Graham states:

Obviously it is desirable that a company show a favourable trend in gross and net earnings. Securities of a company revealing a definitely unfavourable trend should not be bought for ordinary investment — even though the coverage may sit be large — unless you are convinced that the trend will correct itself shortly.

On the other hand, there is danger of attaching undue importance to a favourable trend, for this too may prove deceptive.

So do we just throw out all past data? No. You just have to ask two questions. First, how confident are you that the favourable trend will continue? To find this out, you might look at a company’s position within an industry. Do they have a durable competitive advantage? Do they have high returns on capital?

And second, how much are you willing to pay for that trend? Hence, you would want to pay less than what the favourable trend would yield. You could use the discounted cash flow model to figure this out or, alternatively, use price-to-earnings ratios as a comparative analysis against peers.

But if you ask these two questions before venturing into an investment, you’ll likely avoid high-growth companies that suddenly stop growing.

Regards,

Härje Ronngard,

Junior Analyst, Money Morning

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