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Why This Fantastic Business May Not Be a Great Buy

Several months ago, shares of Morneau Shepell Inc (TSX:MSI) were trading at just under $20 per share, and the potential for new investors entering a new position looked very fair. Shares offered a dividend yield above 4% and had the potential to go up in value.

Fast forward to today, and shareholders entering the security are now receiving a yield of only 3.65%, as shares have risen in value to a price near $21.30. While existing shareholders have done well, new shareholders may have a much more difficult time making the same returns obtained by long-term investors.

While the company may have a fantastic business model and carry a historically low amount of volatility, investors still need to set proper expectations. Given the beta of 0.63, buyers of the security should not expect a large amount of volatility in either direction.

For investors who apply the capital asset pricing model (also known as CAPM), the reward of this security may not be worth the risk.

The CAPM formula for calculating the expected return is as follows:

E(r) = rf + B (rm – rf)

*rf is the risk-free rate of return, B is the beta, and rm is the return of the market.

In the current situation, the risk-free rate of return in Canada is approximately 1.4%, while the long-term average return of the overall market is no more than 10% on average (depending on the selected period). Investors should expect the following return from shares of Morneau Shepell Inc according to the CAPM:

E(r) = 1.4% + 0.63 (10% – 1.4%)

E(r) = 6.82%

Let’s break down the numbers even further. If the dividend yield is currently paying 3.65%, then the capital appreciation for the year will be (on average) no more than 3.17%. For astute investors, this may be fantastic news, whereas others will eventually get very bored by watching the share price of the company do very little on a day-to-day, week-to-week, or even a month-to-month basis. Again, very little volatility actually comes from the shares of Morneau Shepell Inc.

The risks

Although the company operates in a business with clientele that holds a higher level of engagement than traditional businesses, the truth is that the company is currently trading at a trailing price-to-earnings ratio of 42 times while paying out more than 100% of earnings. The potential for capital appreciation may be very limited at current levels.

The company has a healthy market capitalization of over $1.1 billion, and it only trades approximately 50,000 shares per day. During times of stress (or in a recession), things could get very challenging for investors as there are very few exits for investors seeking liquidity.

For investors who seek quality first and a good price second, shares of Morneau Shepell Inc. may fit the bill at a lower price. After all, the company is trading 27% above the 52-week low.

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Fool contributor Ryan Goldsman has no position in any stocks mentioned.

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