It doesn't seem possible that some blue chips are valued at half the market P/E and yield almost four times the market average. But it's true.
How do you know whether a share is cheap?
One way is to look at the P/E or the price you pay for every pound of profit a company makes. By comparing this against the overall market average, you can get a feel for whether a share is cheap. Currently, the FTSE-100 index (Footsie) is valued at around 14 times earnings, so P/Es of less than this may be deemed inexpensive. The table below lists the Footsie's cheapest shares by P/E:
Another way is to compare the dividend payout against the market as a whole. If the yield on a share is significantly higher than the overall market average, then it can be considered cheap. Presently, the Footsie is yielding 3.1%, so shares with higher yields may be thought of as relatively cheap. In the table below, ten of the Footsie's cheapest shares are listed in descending order of yield.
Be careful, though. A company may trade on a low p/e or pay a high dividend for a reason. So with BT Group
(LSE: BT.)
for example, some observers fear that the company's declining voice business may hit profits in the near future.
Drax appears towards the top of both the high-yield and the low P/E lists, which, arguably, makes it the market's cheapest blue chip. On the p/e list it's beaten only by Vedanta Resouces, which is valued at just under half the market P/E.
When it comes to yield, Drax comes in second behind rival electricity generator British Energy, which yields four times the market average. Drax owns one of Europe's biggest coal-fire electricity generators that can supply around 7% of Britain's energy needs.
Drax nearly went bust two years ago when its former US owner AES pulled the plug as energy prices fell. Things could not be more different today. Drax recently announced it had sold almost 90% of this year's output and two-thirds of next year's too. However, it is not easy to forecast energy prices much beyond this, which probably explains why Drax's share price is depressed. The upshot of the low share price is a modest P/E and an abnormally high yield.
Royal Bank of Scotland appears in both lists also. In fact some of the UK's biggest banks, including HBOS
(LSE: HBOS)
and HSBC
(LSE: HSBA)
, boast yields above the market average. But precisely why banks are cheap is a little unclear. Some reckon it may be due to fears of rising interest rates, while others suggest that worries over bad debts may be to blame. This may lead to less certainty over future profits, but you can always find a reason to explain anything in the market.
While the two tables above list some of the FTSE's cheapest shares, it's worth noting that the overall market is seemingly cheap too. A P/E of 14 implies that investors are paying £14 for every pound of profit that companies make. By comparison, the interest rate on most savings accounts is 5%. This means that you need to invest £20 to earn £1 of interest. So whether you decide to pick individual shares or invest through an index tracker, now looks like a good time to get exposure to the stock market.
David owns shares in Barclays, BT Group and Vodafone Group, and iShare FTSE 100, which tracks the FTSE 100 index.
