These cheap shares look 33% undervalued with good future growth to me

Oliver Rodzianko says these cheap shares have a strong future, and analysts seem to agree. But will he buy it after considering the risks?

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Assessing whether I have some cheap shares on my hands or not is always quite tricky. Sometimes, investors at large are willing to pay a premium for a company over the long term. That can make traditional valuation methods obsolete.

But, thankfully, in this case, the firm looks undervalued to me based on future earnings forecasts. What I like about this is it adds a level of security to the investment. But as I will explain, it’s not all roses.

Building wealth

Breedon Group (LSE:BREE) is a notable construction company in the UK and Ireland, and it provides materials like concrete and gravel. Its business strategy includes the acquisition of other companies and, recently, an expansion into the US.

It marked its entry into North America through the acquisition of BMC Enterprises for $300m. But at the moment, 87.2% of its revenue comes from the UK and 12.6% comes from Ireland. Only 0.2% is from other parts of the world.

I particularly like that the company is asset-backed, which means it has high levels of tangible resources and property. That includes cement plants, quarries, and asphalt plants.

Why I consider it cheap

First of all, the shares have a price-to-earnings ratio of just 12, as I write. Over the past 10 years, the norm has been more like 27.5. That means there’s a potential discount at this time of roughly 56%.

However, I also looked at its future earning potential to get a more grounded understanding of its value. Over the next four years, analysts are expecting a compound annual growth rate for earnings of around 5.3%. That’s slower than usual, and as the British economy improves, I expect that to go up to around 10% on average annually over the next decade.

By putting my forecast into a discounted cash flow model, I estimate the company is trading at around 33% less than its worth. However, even if the firm only manages to grow its net income at 5% over the next 10 years, it’s still 7% undervalued based on my model.

Expectations and risks

While the company has a healthy dividend yield of 3%, over the past 10 years, the shares have only gained 64% in price. That equates to a compound annual growth rate of 5%. Let’s compare that to its broader index, the FTSE 250, but also to America’s S&P 500, which I consider one of the greatest index investments in the world. As we can see, Breedon does quite well:

But the investment is also subject to quite a bit of volatility. Notably, its market is heavily influenced by broader economic pressures. Housing market declines can also result in construction companies having less business. So, I wouldn’t want too much of my money in the shares.

Additionally, because its gross margin and operating margin have been declining for a while, I think we could see the firm’s earnings take a hit if this isn’t rectified. Suppliers are raising prices at the moment, so I can see why Breedon has been struggling.

While I don’t consider this one of the best investments for high returns, it certainly seems good and stable to me, with a promising future. So, it’s on my watchlist, but I won’t be investing in it at the moment.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Oliver Rodzianko 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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