A tempting technology PEG

A few weeks ago, I ran the 350 Shares with the highest market capitalisations through Datastream to find those that met the following criteria:

1 Earnings per share growth of at least 100 per cent over the last five years;

2 Earnings per share growth of at least 10 per cent last year;

3 A return on capital employed of at least 20 per cent per annum;

4 Borrowings to be less than 50 per cent of net assets.

Some of the leading companies had not yet reported their 1992 results, so I had to make a few adjustments. I ended up with a list of 15 companies, all of which had at least maintained their dividends during the previous five years. A further sieve of allowing only one earnings setback during the period eliminated Kwik-Fit, leaving me with the 14 shares shown in the table.

I then turned to The Estimate Directory to determine the price the market was expecting investors to pay for the growth record and prospects of each of the 14 companies. In terms of its PEG (the price earnings ratio divided by the growth rate), Micro Focus seemed to offer the best value for money among the top 350 shares, especially as its nearest rivals, Tibbett & Britten and Guinness, are looking forward to a much lower rate of estimated growth in 1994.

Micro Focus is the leading supplier of Common Business Oriented Language (COBOL) software programming tools with approaching 60 per cent of its business in the US and more than 30 per cent in Europe. I cannot pretend to understand the intricacies of the fast-changing computer business, so I rely upon arithmetic and a few broad-brush points:

Micro Focus has recently concluded an important alliance for marketing certain of its products with Microsoft, the industry leader in software.

The company has also just announced the expansion of its long-term relationship with IBM.

The seven leading brokers who contributed to the June issue of The Estimate Directory have written circulars on Micro Focus. Their technical analysts seem to be very impressed with the company's management and its strong position in the industry.

Some technology companies never translate their high hopes for the future and their products and services into profits and cash. In contrast, Micro Focus is highly cash-generative with negligible debt and a very reassuring cash balance of more than pounds 50m, against a market capitalisation of about pounds 320m.

Micro Focus enjoys a massive return of 42 per cent on capital employed - usually a strong sign of a company having a competitive advantage.

A few months ago, when shares touched pounds 30, an American broker caused a scare by downgrading its profit forecast for the company. This sparked off American selling, reducing American shareholdings from 41 per cent to 27 per cent. If you are reasonably sure that an upset of this kind is unjustified, you can see it as an opportunity to buy into a great growth share at a bargain price.

Let us look at the figures in more detail. The financial year ends in January 1994, so I am going to calculate the p/e ratio, the growth rate and the PEG for the next 12 months by averaging the forecast earnings per share for the years ending January 1994 and January 1995.

At the present price of pounds 20.73 with a consensus eps of 145.6p forecast for 1994 and 185p forecast for 1995, I arrive at a prospective p/e ratio of 13, an average future growth rate of 32 per cent and a prospective PEG of 0.4. This seems to me to be remarkably cheap for a new economy growth company with such an outstanding record and well above average future prospects.

The author is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. He has agreed not to deal in a share within six weeks before and after any mention in this column.

----------------------------------------------------------------- THROUGH THE SIEVE ----------------------------------------------------------------- Five-year Return on May eps growth capital PEG % % Argyll 106 21 1.2 Betterware 563 42 0.8 Brake Bros 139 31 4.6 Guinness 143 24 0.6 Halma 113 34 1.2 Inchcape 112 24 1.0 Micro Focus 1002 42 0.4 Rentokil 237 62 1.0 Reuters 138 42 1.4 Rothmans 150 27 1.0 Sainsbury 142 21 1.2 Tibbett & Britten 180 23 0.5 Wellcome 228 34 1.0 Yule Catto 113 34 1.2 -----------------------------------------------------------------