Sometimes, when something hangs around for a while, we think it will be there forever. But nothing lasts that long. That is why if I had spare cash to invest right now I would start loading up on cheap shares while they remain attractively valued.
A lot of UK shares look attractively priced to me right now, relative to their long-term business prospects. I do not expect that to last for long though, which is why I think the time to act is now.
Here are two ways in which I decide whether seemingly cheap shares are attractively valued.
Price and earnings
I commonly look at a company’s price-to-earnings (P/E) ratio. This basically divides the current market capitalisation of a company (its total price) by the firm’s annual earnings.
Imagine if I wanted to buy a company outright. In theory at least, the price I paid could be funded by debt and I could use future earnings to repay that debt. The smaller the P/E ratio, the fewer the number of years it would be before I was debt-free and owned the firm outright.
In practice, things are more complicated. But I still find the P/E ratio a useful tool when hunting for cheap shares. For example, right now, shares in fashion retailer Superdry trade on a P/E ratio of under four. Banking giant Barclays has a P/E ratio of just four. The list of UK shares with low P/E ratios at the moment goes on and on…
Enterprise value
But a P/E ratio might not tell me the whole story. If I wanted to buy a company, I would need to pay the negotiated price. But I would also take on liability for its debts. So rather than focussing just on the market capitalisation, I also consider a firm’s enterprise value. That is the market capitalisation plus net debt, or minus net cash.
Sometimes this can make a firm more attractive. Victorian Plumbing, for example, ended its financial year with net cash of £46m. That allowed it to start paying dividends.
But firms like Vodafone and British American Tobacco are carrying tens of billions of pounds in debt on their balance sheets. Used wisely, debt can be a helpful tool for companies. But as an investor, I need to be aware of it. What look like cheap shares might not be such good value after all when I consider a company’s debt obligations. One reason Superdry shares have fallen so much is concern about how the company can refinance its existing borrowings.
Even a well-run, profitable company can go bankrupt if its cash flows do not match business needs. That is why understanding debt can help me as an investor.
My hunt for cheap shares
I continue to think a lot of UK shares looks undervalued. That will not be the case forever though, so I have been loading up while I can.
In the case of Superdry, I recently bought the shares despite the debt risk. I like the firm’s unique business and think its shares look undervalued.
When hunting for cheap shares, I always focus on finding quality businesses with a competitive advantage. I then consider their valuation. Price alone is not a good indicator to help me find high-quality cheap shares.
