- What are undervalued stocks?
- Top undervalued shares in the UK
- Standard Chartered
- Imperial Brands
- How to find undervalued stocks
- 1. Relative Valuation (Multiples)
- 2. Intrinsic Valuation (Discounted Cash Flow Models)
- Finding undervalued stocks in international markets
- Are undervalued stocks right for you?
Undervalued stocks and shares are abundant in the world of investing. And for the skilled investor able to identify them, a lot of money can be made. Of course, that’s easier said than done. Plenty of companies look “cheap” for a good reason. And these traps can often lead investors astray.
Let’s take a high-level tour of the complex world of valuation, uncovering some of the more promising value investment opportunities available.
What are undervalued stocks?
Undervalued stocks are businesses whose shares are trading below their underlying intrinsic value. With mood and momentum being the primary driving force behind stock prices in the short term, discrepancies between price and value occur constantly. And being able to identify such opportunities can be a highly lucrative endeavour.
These terms, “price” and “value” are often used synonymously in everyday life. But in the realm of finance, there is a stark difference between the two.
To quote famous investor Warren Buffett, “Price is what you pay. Value is what you get”. Buffett is probably one of the most successful value investors alive today. He made his multi-billion-dollar fortune by identifying strong businesses whose share prices were trading below the true worth of the underlying company and then investing in these undervalued stocks.
Top undervalued shares in the UK
Here are some of the top undervalued stocks on the London Stock Exchange.
|Standard Chartered (LSE:STAN)||A global banking institution primarily operating in Asia.|
|Imperial Brands (LSE:IMB)||One of the UK’s largest tobacco businesses transitioning its product portfolio into healthier alternatives.|
|Centrica (LSE:CNA)||A leading energy supplier and utility services business operating through several brands, including British Gas.|
|easyJet (LSE:EZJ)||Europe’s second-largest budget airline nearing a full recovery from the impact of the pandemic.|
|Redrow (LSE:RDW)||A UK homebuilder hitting record order book levels.|
Banking stocks typically outperform the market during times of higher inflation thanks to the subsequent boosts in interest rates, expanding lending margins. For many UK investors, Lloyds is often the go-to bank investment idea. However, Standard Chartered seems to be making bigger waves.
Management recently announced its ambitious goal of delivering an annual return on tangible equity (RoTE) of 10%. Given Standard Chartered’s track record of over-promising and under-delivering, it’s not surprising that many remain sceptical, resulting in a seemingly low valuation.
Yet looking at its 2022 first-quarter results, management seems to be on target. Its cost-to-income ratio has fallen to 62.1% from 74.3%, while RoTE reached 11.1%. Whether these figures can be maintained moving forward has yet to be seen. But so far, the group’s new strategy seems to be paying off.
Imperial Brands is one of the UK’s largest tobacco companies, generating most of its revenue from selling cigarettes. However, in recent years management has begun switching up its strategy by bringing healthier products onto the market, such as heated tobacco, oral nicotine, and vaping devices.
In August 2022, the stock traded at a cheap price-to-earnings ratio of 8.6. But this is nothing new. Like most tobacco companies, the business has always looked undervalued. Why? Because some investors aren’t fond of investing in a company whose products are known to cause severe long-term harm. But consequently, the group yields a pretty massive dividend that continues to return significant capital to shareholders each year.
Centrica is a leading energy and utilities service provider in the UK. Beyond supplying gas and electricity, the group offers a collection of plumbing, drainage, and heating services through its numerous subsidiaries, including British Gas, Dyno, and PH Jones.
With electricity prices rising, the group’s bottom line has started moving in the right direction. And with a long track record of underachieving, it seems investors haven’t been entirely eager to jump on board. Consequently, shares currently trade at a relatively low valuation despite double-digit growth.
It’s possible that the recent jump in profitability is only short term. However, for the time being the stock is trading well below analyst forecasts.
Travel stocks have understandably been pulverised by Covid-19. With travel restrictions emerging worldwide, companies like easyJet have been limping on since 2020. Today the situation has drastically improved, though there remains a long road ahead before a full recovery.
Like many other airline stocks, there remains quite a lot of uncertainty surrounding easyJet. Yet despite this, the group seems to be in a stronger position than most. Its net debt has been steadily falling as it accumulates cash and equivalents on its balance sheet. Meanwhile, passenger capacity in the third quarter of 2022 is expected to reach 90% of pre-pandemic levels, with a near-complete recovery by the end of the year.
The group obviously still has to contend with an increased debt load in a higher interest rate environment. But with fuel costs largely hedged to absorb the impact of rising oil prices, the group looks capable of making a full recovery in the long term. And that could mean its currently depressed stock price is undervalued versus the group’s future potential.
After the pandemic decimated supply chains, homebuilders struggled to source necessary materials to keep up with surging demand. Redrow was no exception, with the stock taking a pretty significant hit as a consequence.
Today, shares are still trading below pre-pandemic levels. Yet that’s despite the latest interim results showing superior revenues, profits, and a record order book. With interest rates rising, affordability for new homes is starting to suffer, which undoubtedly affects the group’s ability to sell its properties.
But in the long run, demand for housing isn’t going anywhere. And with the share price currently trading around six times earnings, this stock looks undervalued.
How to find undervalued stocks
There are two common methods to determine value:
1. Relative Valuation (Multiples)
Starting with the easiest of the two, the relative valuation method doesn’t actually try to pinpoint the value of a company. Instead, it compares it with other businesses operating in the same or similar industry to see at what price point the shares are trading relative to another stock.
This is where financial metrics such as the price-to-earnings ratio and price-to-sales ratio steps in. Stocks trading at a P/E or P/S ratio below the industry average are considered undervalued. Similarly, those trading above the average are considered overvalued.
2. Intrinsic Valuation (Discounted Cash Flow Models)
The problem with the relative valuation method is that it makes many broad assumptions. Every business is unique in some way, which can skew results when compared with other companies, even if they operate in the same space. It’s entirely possible for a stock to trade above its industry average and still be undervalued.
This is where intrinsic valuation comes in. Unlike the relative, this method attempts to estimate the underlying value of a company based on the present value of its future cash flows using something called a Discounted Cash Flow model (DCF).
DCFs are a bit of a rabbit hole. But in oversimplified terms, an analyst forecasts the revenue stream for the next 5-10 years along with profitability to calculate the group’s future cash flows. These cash flows are then discounted back to present-day value at a rate reflecting the risk level associated with the stock.
Calculating a sensible discount rate in and of itself can be a challenge. A typical go-to figure is 10%, but this can often be too little or too much, depending on the company.
Once cash flows have been translated into present-day value, it’s then converted into equity value, which is the equivalent of market capitalisation. This can then be compared to the current share price to determine whether a stock is undervalued or not.
Needless to say, intrinsic valuation is far more time-consuming and challenging than relative valuation. However, it’s also more reliable, providing the analyst can produce accurate and reasonable forecasts – something that can be challenging to achieve.
Finding undervalued stocks in international markets
The core principles in identifying undervalued stocks and shares in international markets remain pretty much the same. However, there are some key differences to be aware of.
Depending on the location, the difficulty of accessing additional capital, either through debt or equity, can vary wildly.
If taking a relative valuation approach, performing a multiples comparison against other related companies operating in the same country is important.
If taking an intrinsic valuation approach, the discount rate needs to be adjusted to reflect both the difficulty of accessing capital and the risks of operating in certain countries.
For example, accessing capital as a business in the US is far easier than in Brazil. But there is also the factor of the operating environment to consider. An American oil company might have easy access to funds, but if drilling is actually done in a more politically unstable region, the risk and impact of potential disruption need to be reflected in the discount rate.
Are undervalued stocks right for you?
Charlie Munger once said all investors are value investors. And in many respects, he’s absolutely right. After all, we’re all trying to pay a low price today to eventually sell at a higher price in the future. However, being a value investor requires a lot of knowledge and, more importantly, patience.
Undervalued stocks and shares can continue trading below their true value for months or even years. And it’s easy to lose faith in your original valuation model. After all, there is always the possibility that you were wrong. That’s why this strategy is not suitable for everyone. But for those who dare to go against the crowd and arm themselves with detailed analysis updated as new information comes to light, achieving long-term, market-beating investment returns becomes far more achievable.