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2 bargain stocks for under a fiver

Royal Mail: Fair use

It’s been a good year for shareholders of outsourcing group G4S (LSE: GFS). Their stock is worth 30% more than it was three months ago and 64% more than one year ago. Remarkably, G4S stock is now within a few pence of its 2013 all-time high.

You may think that this rules out any chance of G4S qualifying as a bargain stock. But I’m not so sure. A company’s historic share price is rarely a guide to the future. What really matters are its earning power and its valuation. G4S scores quite well in both areas.

Impressive results

The firm’s recent results showed that chief executive Ashley Almanza is getting to grips with the group’s problems. Revenue rose by 6.3% to £6,823, excluding currency movements, while net profit rose by 16% to £246m.

The group’s adjusted operating margin rose slightly from 6.4% to 6.7%, but G4S’s improved performance was most visible in terms of cash flow. The group’s operating cash flow rose by 61.5% to £638m last year.

By my calculation, free cash flow excluding acquisitions and disposals rose by 275%, from £78m to £292m. I’ve calculated this amount after interest payments, so it shows the surplus cash available to G4S to repay debt or pay dividends.

Debt remains a concern, but the situation is improving. The group’s net debt-to-EBITDA ratio fell from 3.4 times to 2.8 times last year. That’s still high, but further profit growth could bring this ratio down rapidly.

Is there more to come?

Looking ahead, G4S trades on a 2017 forecast P/E of 16.5, with a prospective yield of 3.3%. Earnings per share are expected to rise by 27% this year and by 9% in 2018.

I think that’s enough to justify the stock’s current valuation, but it’s possible that the group’s actual earnings will be higher. Broker forecasts for 2017 have been upgraded by 10% over the last year. With such strong momentum, further upgrades may be possible.

I’m encouraged by G4S’s rapid turnaround. While debt remains a risk, I think the shares offer decent value at current levels.

A more controversial choice

G4S’s strong performance has won the firm plenty of fans over the last year. That’s not true for my second pick, Royal Mail (LSE: RMG).

Shares in the UK postal operator have fallen by nearly 15% over the last six months. Investors are concerned that Royal Mail won’t be able to adapt successfully to the increasingly rapid shift from letters to parcels. There are also concerns about regulatory risks and the possibility of strike action.

I think these concerns are probably being overdone. Royal Mail has been operating for more than 500 years and has been through many cycles of change before. The company has made good progress with long-overdue modernisation and this spending is now starting to moderate. Net cash investment in the business is expected to be “no more than £500m” per year from now on, down from an average of £615m over the last three years.

This should free up cash to support the group’s dividend, which currently offers a prospective yield of 5.5%.

With the stock trading on a forecast P/E of 11, I remain a buyer and have recently added to my own holding.

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Roland Head owns shares of Royal Mail. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.