What’s the difference between cheap shares to buy and value traps to avoid? In theory, the answer is easy: it’s quality.
But what does this mean in practice to someone wanting to make a share purchase?
To be successful when investing, we need to maximise our returns. This means being able to find shares in solid, dependable businesses that the market has currently underpriced.
There are many great businesses on the FTSE and there are many low-priced businesses on the FTSE too. However, to make a sound investment throughout these times of economic uncertainty and stock market volatility, you need to find a business that is both. Only then can we make the claim that they’re truly cheap shares to buy now.
Two quality stocks…
Two of the most solid and dependable FTSE constituents, in my eyes, are Taylor Wimpey (LSE: TW) and British American Tobacco (LSE: BATS). Both firms are profitable and have solid balance sheets, albeit BATS carries more debt than I would like.
However, the majority of BAT’s debt is due to its purchase of Reynolds American (the maker of Newport, Camel, and Grizzly Snuff brands) in 2017. This purchase gives BATS access to the US tobacco market. This region accounts for 25% of global cigarette sales and 45% of global e-cigarette and vape sales. The acquisition is a highly strategic one with much growth potential for future profits.
For the remainder of this year, BATS is planning to grow its margins and to convert 90% of operating profit into cash flow. It also plans to return 65% of earnings per share (EPS) to shareholders as dividends. With these figures, it is a cash-converting machine, and one that offers a current 6.8% yield. This must be one of the best returns on the FTSE 100 right now.
Taylor Wimpey is also still paying out dividends, albeit at a lower 2.6%. However, the residential developer has recorded dividend growth in four out of five years since 2016. With at least five years of sequential positive earnings and a 2019 return on equity (ROE) of 20.6, the firm’s management is proving itself to be a profitable one.
…and also two cheap shares to buy
Buying an overpriced share, even a great quality one, lowers your returns. So the share price valuation must be relatively cheap to make it worth your money.
A great valuation metric to determine cheap shares to buy is the earnings yield. This figure provides a rough gauge of the overall value of a stock. An average earnings yield is around 5%. British American’s current yield is above average, at around 7.8%. But Taylor Wimpey’s is an astonishing 18.6%.
Taylor Wimpey is currently trading around 152p, and at a price-to-earnings ratio (P/E) of 7, far below the pre-pandemic industry average of 19. The firm has an overall 10-year trend of rising share prices, indicative of good management. I would expect this to continue. However, it is currently a cheap share to buy.
BATS is currently trading at a P/E of 12, again below its pre-pandemic industry average of 13. However, due to the nature of its products, the firm was not significantly affected by the pandemic. Its share price plummeted after that 2017 acquisition, but has been steadily climbing ever since. Unless there are big upsets to its strategy, it’s likely this will keep going.
