How do we find the best value stocks? That’s an age-old question, and we all have our own favourite measures.
The price-to-earnings (P/E) ratio is a common one. It measures how much earnings we should get if we bought a stock today.
Generally, the lower the P/E the better. A stock on a P/E of 10 would earn 10p in a year for every £1 we invest. If the P/E is 20, we’d expect only 5p in earnings.
But so much can throw off the P/E. Forecasts make a big difference — there’s no point valuing a stock on last year’s earnings if we expect them to soar next year.
Need to adjust
Then debt comes into it. BT Group is on a P/E of 7.4, which looks low. But it carries huge debt. We can adjust for that, and it gives us a debt-free equivalent P/E of 20. That doesn’t seem so cheap.
The most important stock valuation measure for me is the dividend yield. That’s for a few reasons, but mainly because I buy for dividends these days so I can reinvest the cash each year. It makes sense to focus on the thing I want the most.
Yields alone aren’t good enough, though, and I want to be convinced that the cash is sustainable in the long term.
10% dividend!
I rate Phoenix Group Holdings (LSE: PHNX) as a top value stock, with a 10% dividend.
But I see one immediate red flag. Going by forecasts, it looks like earnings won’t come close to covering the dividend cash. Maybe that’s why investors haven’t been snapping up the shares to bag their 10%.
That and the way insurance firms are suffering right now. Phoenix recorded a loss last year, and it hurt.
But it’s a cyclical sector, and earnings can swing wildly in the short term. Over the long term, I rate this a cash cow business.
At the interim stage, the company spoke of “a sustainable dividend that grows over time“. And it expects close to £1.4bn in cash generation for the full year.
More big yields
I also rate NatWest Group as a top value stock, and again it’s down to the dividend. This time, it’s a 7.1% yield. And a low P/E of five backs it up.
It’s another sector that’s suffered, and looks very uncertain this year. But the FTSE 100 banks generate bags of long-term cash.
For something completely different, British American Tobacco is on my list of top value stocks too. There’s another 10% dividend here. And it looks like it should be well covered by earnings.
The big risk is the trend against tobacco, which does concern me. But I don’t share the thought that the business is set to disappear. And the proft margins are fat.
In common
In short, these are three very different stocks (with different P/E values). But they share what matters to me. Strong dividend policies, and businesses that I think can earn the cash to support them.
