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Would Warren Buffett buy The A2 Milk Company Ltd (ASX:A2M)?

It’s the best performing share in the ASX 200 over the past year, but is the A2 Milk Company undervalued enough for someone like Warren Buffett to invest in it?

One of Buffett’s rules is to understand the business, so let’s have a closer look at The A2 Milk Company Ltd (ASX: A2M).

The Company

The company is involved in the producing, marketing and selling of branded dairy and infant formula products in targeted global markets. Since its public listing in 2015, purchasing shares for $0.50c would have earnt you Berkshire type returns with today’s $10 share price.

With market capitalisation at $7.2 billion, The A2 Milk Company has a purchase price that is 42 times that of earnings and 31 times its net assets. Based on these figures, the market is suggesting there is significant growth to come.

The Future

For the 9 months ended 31 March 2018, a2 Milk’s revenue increased 70% on the prior corresponding period. As such, projected earnings per share for the 2018 financial year of $0.25c are more than double than that of last year’s $0.12c per share.

Furthermore, forecasts are indicating that by 2020, earnings per share will reach $0.44c which means if you bought on today’s prices, you’re locking in a P/E ratio of approximately 23. Thus, the stock is relatively expensive.

Despite these elevated prices, a large broker has labelled this stock a strong buy with a 12 month target price of $12.80. But would Warren Buffett agree?

The Market

The ‘Oracle of Omaha’ loves companies with distinguishable and hard to replicate competitive advantages. Whilst it appears as if The A2 Milk Company lacks this, the opportunity within the Chinese market may act as a substitute.

As a result of the one-child policy extension in 2015, China’s population is continuing to grow. In addition to its expanding middle class, it’s no surprise that China spends an enormous $20 billion on infant formula each year.

China and other parts of Asia have contributed $114.4 million towards revenue in the first half of FY 2028. As such, it accounts for approximately 26% of total revenue and underpins growth potential.

Whilst the A2 Milk Company has additional sources of revenue through the UK, USA, Australia and New Zealand, the current price and projected earnings are very much built on expected growth throughout the Chinese and Asian markets.

Foolish takeaway

The A2 Milk Company is a fundamentally sound business with probable market growth. However, it is relatively nascent with little chance to prove itself as a historically strong business. This in combination with its high valuation suggest Warren Buffett as a famous investor in today’s blue chips would look elsewhere.

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Motley Fool contributor Matt Breen has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of A2 Milk. 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 Scott Phillips.

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