There are many different types of investing strategies. Recently, the surge in retail traders pumping up stock prices has shone the spotlight on momentum investing. This is when investors jump on the back of an existing move higher in a share price. Another strategy is income investing, buying stocks for the dividend payouts. A strategy I particularly like is value investing. This involves me picking UK shares that are undervalued and buying them when I think they’re cheap.
How can I tell if a UK share is undervalued?
But what does cheap mean? There isn’t one particular metric used to tell if a UK share is undervalued. If there was, then everyone would have the golden formula, and a stock would likely always trade at that price!
One metric is the price-to-earnings ratio. This measures what premium I’m paying for buying a stock. Is it 10 times earnings, 20 times, 100 times? Obviously buying a stock that trades at 100 times earnings could be viewed as overvalued. To get a comparative figure, the FTSE 100 average is around 17.5.
Another valuation technique is the enterprise value. This is a measure of the net-worth of a business, taking into account debt levels along with cash and tangible assets. I can compare this to the market capitalisation of the company. The market capitalisation is the stock price multiplied by the number of shares available. Although the enterprise value stays fairly constant, the market capitalisation fluctuates all the time, depending on the stock price.
Even these two measures aren’t 100% reliable. A P/E ratio may be low as profits are falling, so it might not be a good undervalued stock to buy. The enterprise value might only be calculated a couple of times a year when the latest financial results come out. So it’s not always easy to get an up-to-date view on the value.
Some stocks that I think are undervalued
Both Barratt Developments and Legal & General have P/E ratios below 9. This is substantially below the FTSE 100 average and so make the UK shares look undervalued to me. Barratt is a UK housebuilder showing good signs of recovering from Covid-19. Home completions for H2 2020 were up 9.2% on the previous year, with forward sales for 2021 up 14.3%.
Legal & General is a financial services company that has ridden out the pandemic well. The business is also one of the few within the FTSE 100 to keep paying out dividends. The dividend yield has been above 6% for the past year, which is another reason (aside from the valuation) that makes it look attractive in my eyes.
As I wrote last week, Lloyds Banking Group shares have seen a steep fall over the past year. This means the market capitalisation is £24.6bn versus an enterprise value of £34.8bn. If we assumed the UK share rose to a point where it equalled the enterprise value, it would price the stock around 49p. This is in comparison to a share price of 34p currently.
All of the above stocks could be seen as risky. My figures of valuation are subjective. Therefore they could all move lower in the short-term, and not return to a fairer value for a significant period. This is a risk, but I think my long-term timeline increases my chances of a positive return.
