How do you go about finding new stock ideas?

If you’re anything like me, it probably includes running investment screeners every now and then. If you see yourself as a value investor, you might use measures like price-to-earnings and dividend yield to narrow the field.

Like most investors, I have used these ratios a lot. To the extent that seeing a share trading above a certain level on either measure invokes a sort of reflex. A dividend yield of over 5% and I lean in – my lizard brain says the stock might be cheap. A P/E ratio much over 20 and I find it hard not to click away – the opportunity must have already been and gone.

I realise that this is stupid. And the more I think about it, the more I realise that P/E and dividend yields are popular for their simplicity just as much as their value. The problem, unless you specify a forward P/E or dividend yield based on estimates, is that both metrics are usually backwards looking. Meanwhile, the things that will impact your investment return are all in the future.

This makes it entirely possible that a stock that looks “expensive” based on a backwards looking P/E ratio can turn out to have been very cheap. A share with a rich dividend yield based on last year’s distributions could leave with you no income at all. I wrote about this in how to avoid dividend disaster.

This serves as a reminder of what makes a share valuable in the first place. A share is an equity claim on the future cash flows of a business. As a result, it is the future cash flows that matter. A low trailing P/E multiple is often a symptom of a cheap stock. But it doesn’t make a share cheap in itself – and vice versa.

With that in mind, today we’re going to look at three stocks that meet two criteria:

  • A high share price relative to recent net income. As a result, they might not pop up in your average “value” stock screen.

  • A low share price relative to our analysts’ estimate of fair value.

Let’s get the biggest trailing P/E multiple out of the way first. If you aren't familiar with them, Morningstar’s use of Star Ratings and terms like Fair Value, Moat and Uncertainty Rating are all explained at the foot of this article.

SkyCity Entertainment ★★★★★

Moat rating: Narrow
Uncertainty: High
Trailing P/E ratio: 151x
Price to Fair Value: 0.48 (as of 7/6/2024)

Casino operator SkyCity Entertainment (ASX: SKC) trades at over 150 times last year’s net income. But everything is not as it seems. The high trailing P/E ratio is largely due to SkyCity’s 2023 net income being heavily depressed by one-off charges. The company's underlying earnings, which are adjusted for those one-off costs, were far higher but were affected by cyclical weakness.

Regulatory headwinds have weighed heavily on SkyCity’s shares recently. AUSTRAC fined the firm $67 million for past failures to comply with anti money-laundering rules. In addition to this, the firm’s Adeleide license is under review and a ten-day suspension of the New Zealand casino licence is likely due to alleged breaches of harm minimization laws. If that wasn’t enough, the shares have also been hit by concerns regarding a weaker consumer and worries that big investments to improve its Auckland and Adeleide premises won’t pay off.

Now for the good news. Morningstar’s SkyCity analyst Angus Hewitt expects SkyCity to deliver strong earnings growth over the next decade, buoyed by a recovery from cyclical lows and solid performance from SkyCity’s core assets in Auckland and Adelaide. Hewitt also thinks a loss of the Adelaide casino licence is unlikely. But he does note that regulatory and compliance costs are up sharply and could be permanent.

Hewitt thinks SkyCity has a fair value of $3.10 per share, with an Uncertainty rating of High due to regulatory risks. He gives SkyCity a Narrow Moat rating due to its regulated monopoly position in Auckland and Adeleide. The firm has long-dated licences in both cities, with an exclusive licence for Auckland until 2048 and exclusivity in Adelaide guaranteed until 2035. ★★★★★

Moat rating: No moat
Uncertainty: Very High
Trailing P/E ratio: 73x
Price to Fair Value: 0.40

Shares in online retailer (ASX: KGN) have suffered as the company grapples with muted consumer demand. Kogan’s stock has fallen almost 20% in 2024 but still trades at 73 times the company’s 2023 earnings. What matters, though, is the future.

Morningstar’s Johannes Faul thinks Kogan can record healthy revenue growth and higher profit margins. He projects group revenue growth to average 5% per year over the next decade with a big uptick in EBITDA margins from 1% to around 10%. At a price of around $4.30, the shares look cheap for long-term investors. 

Faul assigns Kogan a fair value of $10.70 per share with an Uncertainty rating of Very High. This reflects the potential for intense competition and the cyclical nature of selling non-essential goods. Faul doesn’t think Kogan has a moat but does expects it to achieve high returns on capital due to the structural tailwind of online migration, the ramp up of its marketplace, and being a capital light business by nature.

Kogan's No Moat rating stems from the ease of comparison shopping online and the increased competition Kogan is seeing from Amazon and omnichannel retailers. Kogan’s initial cost advantage from sourcing direct from manufacturers and selling online has also eroded as the practice became widespread. While its 4 million and rising customers across Australia and New Zealand make Kogan’s platforms more valuable to third-party brands and advertisers, they are far from achieving a dominant network effect.

Domino’s Pizza Enterprises ★★★★

Moat rating: Narrow
Uncertainty: High
Trailing P/E ratio: 57.5x
Price to Fair Value: 0.64

Domino's Pizza Enterprises (ASX: DMP) is the Australian master licence holder of the Domino's Pizza brand. It also has operations in New Zealand, Japan, Singapore, Malaysia, France, Germany, Belgium, Luxembourg, Taiwan, Cambodia, and the Netherlands.
As a master franchisee, Domino's has limited capital requirements, which means royalty payments it receives in the future should continue to be paid as partially franked dividends. This makes returns on invested capital very attractive and has traditionally led to a rich P/E ratio, which currently stands at over 57 times last year’s earnings.

Domino’s shares have endured a torrid run stretching back to 2021. As well as concerns about a weaker consumer, cost pressures have squeezed profitability across the food service business. This has reduced profits for Domino’s franchisees and led to slower store openings. It has also eaten into profits at company owned locations, which make up around a quarter of the firm’s total store network.

Despite this bump in the road, Johannes Faul thinks Dominos can still increase its Australian store base by about one third in the next few years. The growth opportunity in its European markets looks more substantial, with the potential to more than double its existing store base to around 2,900 outlets during the next decade. Thanks to the attractive economics of franchising, this could result in materially higher earnings down the road. Faul thinks the shares have a fair value of $61 versus a price of around $38 today. He attached an Uncertainty rating of high to that valuation given Domino’s fundamental exposure to the economy and economic cycles.

Domino’s Narrow Moat rating stems from very strong global brand recognition, other intangible assets and cost advantages versus smaller operations. In addition to its brand, Domino’s has highly valuable intangible assets in the form of internally generated intellectual property. The firm is a leader in restaurant logistics and has developed technology tools that build and maintain customer engagement and loyalty. Faul thinks its investments in streamlining its cooking and fulfilment process makes it the "go-to" location for individuals who covet the fastest and most reliable service.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.