As Shani and Mark explored in a recent episode of the Investing Compass podcast, Pro Medicus (ASX: PME) has been the last decade’s best performing ASX share in Morningstar’s coverage universe.

At the time of that podcast, Pro Medicus shares had returned an average of 63% per year over the past ten years – enough to turn every $10 invested into over $1300. The magic formula? Rapidly growing revenue and profits combined with sky-high valuation multiples for the shares.

That trifecta continued to work its magic after Pro Medicus announced its full-year results this week. The shares are now up over 50% this calendar year and more than 100% ahead over the past twelve months.

Our analyst Shane Ponraj sees a lot to like about Pro Medicus’s business but thinks the shares look materially overvalued.

How does Pro Medicus make money?

Pro Medicus is a healthcare IT company specialising in radiology imaging software.

Its main product, Visage 7, is a clinical desktop application that radiologists use to view, enhance, and manipulate images from any device and make a diagnosis. The company's customers are mostly US private academic hospitals.

Pro Medicus' strategy revolves around renewing existing contracts with hospitals and winning new clients for Visage 7 while increasing prices. It has a high win-rate for tenders, which often involve on-site pilot tests. Ponraj thinks this highlights Visage 7’s superior speed, scalability, and resilience compared to the competition at present.

Visage 7 is currently limited to radiology departments but Pro Medicus is aiming to extend the product set to other specialty departments including cardiology and ophthalmology. The firm also has other offerings such as Open Archive or Visage RIS that it can cross-sell to clients after winning contracts.

What was so good about Pro Medicus’ 2024 earnings?

Pro Medicus reported 34% growth in underlying earnings before interest and tax (EBIT) to $112 million. This came from a 26% increase in revenues and an improvement in EBIT margins (the amount of revenues kept as pre-tax profits) to 70%.

This improvement in margins defied Ponraj’s expectations that some of Pro Medicus’s expenses like travel and marketing would bounce back after the pandemic. He increased his Fair Value estimate for the shares by 7% on account of this improved profitability, but his estimate is still far below the levels Pro Medicus shares currently trade at.

Priced to perfection?

Pro Medicus shares currently trade at almost 150 times Ponraj’s forecast for earnings per share in 2025. As we explained before earnings season, a high valuation can give a company less room for error when it comes to their results. If the company stumbles – or simply reports good as opposed to great results – it can lead to weakness in the shares.

Pro Medicus reported strong results this time but looks vulnerable in this regard.

Ponraj feels that a lot of expectation is baked in to the current share price. To reach the market’s valuation of Pro Medicus, he estimates that he would need to assume midcycle profit margins of almost 90% and a 10-year average revenue growth rate of above 25%. This is worlds away from his forecast for profits of around 70% and 11% annual growth.

Competition looming?

Due to its low capital requirements and high profit margins, Pro Medicus enjoys high returns on invested capital. In fact, the firm's investments back into the business have yielded returns of 40%+ in each of the past five years.

These kinds of profits do not go unnoticed and were always going to attract competition. Ponraj thinks markets underestimate this threat.

Although switching costs make it less likely that Pro Medicus will see its existing customers move to other providers, winning tenders at higher prices may get harder once other providers develop more competitive products.

There are signs that this is already happening, as bigger firms like Philips harness technologies like server-side rendering, cloud-native architectures and AI to narrow the gap between their solutions and Visage 7.

This could also eat into Pro Medicus’ margins and returns on capital by forcing them to fund more research and development to maintain a leading position.

A further weight on sales growth?

As we covered earlier, Ponraj’s forecast revenue growth rate appears to undershoot the market’s expectations.

On the positive side, Ponraj feels the key US market can deliver mid-teens growth over the next five years as Pro Medicus wins new contract tenders and extends its offering to other hospital departments.

However, the firm’s growth could be tempered by tougher competition and its core market of private academic hospitals becoming saturated. Private academic hospitals are generally well funded and have more use for advanced technology and features that attract higher prices. Other hospitals may have less need for these features and be less willing to pay up.

Overall, Ponraj has a positive view on the outlook for Pro Medicus’s business. He just thinks the shares look too expensive.

His Fair Value estimate of $37 per share is roughly four times lower than the current price of $146. As a result, the shares command a 1-star Morningstar rating.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.