Rising inflation will hurt this firm’s bottom line but long-term growth will follow

Questor is The Telegraph’s stockpicking column, helping you decode the markets and offering insights on where to invest for the past six decades.

The near-term outlook for technology company Sage is highly uncertain. The FTSE 100-listed firm, which provides accounting and payroll solutions to small and medium-sized businesses, could be negatively impacted by sticky and rising inflation across the developed world.

Indeed, while the company has a diverse geographic footprint, inflation across key markets – including the US, Europe and the UK – has remained persistently above central bank targets. This may lead to a slower pace of monetary policy easing over the medium term that prompts a squeeze on profits across a wide range of sectors.

This could mean that Sage is less able to raise prices for existing customers and is less successful in winning new ones. While previous interest rate cuts are likely to have a positive impact on the economy’s performance following the expiry of time lags, the scale of monetary policy easing enacted thus far across developed markets may be insufficient to provide a material boost to GDP growth.

In Questor’s view, however, the company remains highly investable. Although it faces a tough near-term future, its long-term prospects are extremely upbeat. Ultimately, inflation is very likely to settle at, or close to, central bank targets, thereby providing scope for significant interest rate cuts that catalyse demand for the firm’s services and bolster its financial performance.

In the meantime, the company is performing much better than many investors may naturally assume amid an uncertain economic environment. Its latest trading update, released in January, showed that revenue grew by 10pc during the first quarter of its financial year. Guidance for the full-year was unchanged, with the firm currently forecast to deliver annualised earnings per share growth of 15pc over the next two years.

The company’s trading update also showed that the proportion of its sales which are recurring rose by 0.5 percentage points year on year to over 97pc. This should mean that it benefits from an increasingly stable and predictable financial outlook, which may prove beneficial given the potential for economic challenges over the coming months. With a return on equity figure of 26pc, the business appears to have an extremely sound competitive position that bodes well for its long-term growth.

Sage’s financial standing, meanwhile, indicates that it is well-placed to overcome possible economic difficulties in order to capitalise on an eventual upturn in operating conditions. Its net gearing ratio, for example, is 68pc, while net interest costs were covered over 17 times by operating profits in its latest financial year. Both figures show that it has the capacity to make further acquisitions to boost growth following several purchases over recent years.

A sound balance sheet additionally allows for ongoing investment in new products, including those which use artificial intelligence. This may not only provide a further growth catalyst, but could also prompt improved investor sentiment towards the firm’s shares.

Of course, Sage already trades on a lofty price-to-earnings ratio of 31.9. Its market valuation has increased dramatically since the stock was tipped as a ‘buy’ in this column during June 2021. It has risen by 76pc, which is 52 percentage points ahead of the FTSE 100’s increase over the same period.

Although a material increase in its P/E ratio, which was 25 at the time of our original tip, seems unlikely, the firm’s double-digit earnings growth forecasts mean it is poised to deliver further capital gains. It therefore becomes the latest addition to our wealth preserver portfolio, with existing cash generated from recent sales being used to fund its notional purchase.

Clearly, it would be unsurprising if the company’s shares experience heightened volatility in the short run amid an uncertain economic environment. After all, the company’s financial performance is highly dependent on the operating conditions experienced by small and medium-sized businesses. They could remain challenging as above-target inflation and a slower pace of interest rate cuts persist.

Given that Questor has a multi-year time horizon, though, we are rather disinterested in short-term share price performance. On a long-term view, Sage remains a highly appealing investment that offers significant capital growth potential.

Its sound financial position, clear competitive advantage and strong earnings growth prospects mean it is well-placed to further outperform the FTSE 100 over the coming years.

Questor says: buy
Ticker: SGE
Share price at close: 1188.5p