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Revealed: Which share market darling could be crushed next

Investors in Australia’s seemingly most promising growth stocks have had the rug pulled from beneath them recently, with a raft of downgrades to Blackmores Limited (ASX: BKL), iSentia Group Ltd (ASX: ISD), Vita Group Limited (ASX: VTG), and more.

In addition to keeping an eye on the prospective bargains that these companies offer, investors might also want to take a look at which other high-flying stocks in their portfolio could be the next to tumble.

Both Fisher & Paykel Healthcare Corp Ltd (ASX: FPH) and REA Group Limited (ASX: REA) are trading on a lofty ~30 times earnings, and both companies have already retreated from previous highs of $10 and $60 respectively.

Fisher & Paykel in particular is trading at 30 times this year’s forecast earnings, and may be just fine given that management recently upgraded its forecasts, again. Yet investors do need to be aware that prices of 30 times earnings are not usually sustainable in perpetuity.

REA Group however has shown signs of slowing down, with Australian listing volumes plunging during the last quarter, despite a rise in revenue.

Aconex Ltd (ASX: ACX) is another company at risk of being re-rated, with the company’s market cap of $850 million a rather elevated 38 times its forecast EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation), not even forecast profits.

Domino’s Pizza Enterprises Ltd. (ASX: DMP) is another company at risk, with its business currently valued at 61 times its trailing earnings, or 47 times its forecast earnings for 2017. Now Domino’s is delivering phenomenal Same Store Sales (SSS) growth of 12% per annum in its Australian stores, and 6% in Europe, and is a great business. Yet its balance sheet carries a fair chunk of debt, which could mean the company won’t be able to grow as much by acquisition, or alternatively that a capital raising may be necessary at some point.

A market re-rating?

If some negative event causes the market to reconsider the way it values a company, shareholders stand to lose. To put it in perspective, if Domino’s were re-rated to the market-average Price to Earnings (P/E) ratio of ~16 for example, the company’s value would fall by around 66%.

If the downgrade was a forecast for substantially lower growth, for example, Domino’s would still be an attractive global business with a highly capable CEO – well worth owning – but recent buyers would still lose half their investment on paper.

So in addition to making sure a company is a great business, investors also need to either a) be sure it will continue to justify today’s prices, or b) commit for the ultra long term, where a 50% decline won’t matter when your great business can grow profits for 5 years or more.

This is necessary because, as we’ve seen recently, managerial forecasts of future earnings are not always accurate. Sirtex Medical Limited (ASX: SRX), iSentia, and Vita Group in particular have been savagely downgraded after previously bullish forecasts had to be revised.

For ordinary shareholders, it can be very difficult to avoid these, given that a number of experienced fund managers and investors were caught out by Vita Group and other reversals. One possible solution is to limit the number of highly priced companies in your portfolio, and to diversify.

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Motley Fool contributor Sean O'Neill owns shares of Sirtex Medical Limited. The Motley Fool Australia owns shares of ACONEX FPO. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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