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Why I think Royal Mail shares are still undervalued

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Royal Mail (LSE: RMG) shares jumped last week after the company announced a bumper £200m special dividend for investors. As well as this windfall payout, the organisation is also planning to return another £200m to investors by repurchasing shares

The group’s profits have surged over the past two years as the business has benefitted from the shift to online spending during the pandemic. It achieved a £311m pre-tax profit in the six months to 26 September. Revenues rose 7% year-on-year, to £6.1bn.

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I think these figures show the jump in sales and shipping volumes the company experienced last year was not a one-off. The shift towards higher levels of spending online seems to be here to stay. And Royal Mail should continue to benefit from this. 

As such, even after the stock’s performance over the past week, I think Royal Mail shares remain undervalued. 

Investing for the future 

Before last week’s jump, shares in the delivery group were failing to attract investor interest. As I have noted before, one of the reasons the market was giving the business the cold shoulder seemed to be Royal Mail’s vast capital spending plans. 

Earlier this year, the group said it wants to spend hundreds of millions of pounds upgrading its infrastructure. Management warned this would have an impact on profitability. 

However, it looks as if the business is already reaping the rewards of this spending. After struggling to meet customer demand last year, management thinks the group is now well-placed to deliver Christmas as expected this year. Investments in new lorries and sorting equipment should help the business deal with the volume surge. 

That is not to say that the firm can rest easy after this period of investment. It is still facing fierce competition, especially in cities where competitors can achieve the economies of scale required to succeed in the low margin delivery business. Headwinds, such as higher fuel prices and wage inflation, may also weigh on the group’s growth as we advance. 

Still, the company’s efforts to improve efficiency should help offset some of these pressures, especially in the near term. 

Royal Mail shares: valuation 

I think all of the above means that Royal Mail is now in a great position to grow over the next few years. With its capital spending plans progressing as expected, the business is becoming more efficient. This should help increase efficiency and reduce costs.

Ultimately, that will mean better returns for investors in the long run. I think last week’s special dividend could be just the start. 

Considering the company’s outlook, I think Royal Mail’s current valuation undervalues the shares. The stock is trading at a forward price-to-earnings (P/E) multiple of 8. Historically, the shares have commanded a multiple in the mid-teens.

Based on this valuation, I would buy the stock for my portfolio today. 

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Rupert Hargreaves has no position in any of the shares mentioned. 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.

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