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This P/E Suggests Vodafone Group plc is a Buy

The FTSE 100 has risen by more than 85% since it hit rock bottom in 2009, and bargains are getting harder to find.

I’m on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I’m using a special version of the price to earnings ratio called the PE10, which is one of my favourite tools for value investing.

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The PE10 compares the current share price with average earnings per share for the last ten years. This lets you see whether a company looks cheap compared to its long-term earnings.

Today, I’m going to take a look at the PE10 of the UK’s largest listed telecoms company, Vodafone (LSE: VOD) (NASDAQ: VOD.US).

Is Vodafone’s PE10 misleading?

Vodafone has a history of acquisitions, some of which have arguably been overpriced. As a result, Vodafone also has a history of making large goodwill impairments, such as last year’s £7.7bn write-down of its recession-struck businesses in Spain and Italy.

All of this means that Vodafone’s reported earnings have often been much lower than its headline gross profit and revenue figures would suggest. This gives the company’s shares a very high PE10, as these figures show:

Vodafone 12.4 122.0

Goodwill impairments are not cash losses, and so do not affect the underlying profitability of a business. Although Vodafone’s reported earnings per share were just 0.87p last year, its adjusted earnings — which excluded impairments — were 15.65p per share, giving Vodafone a trailing P/E ratio of 12.4.

This is substantially lower than the FTSE 100 average of 16, and given Vodafone’s above-average yield of 5.3%, suggests that the telecoms operator could be a strong buy.

Is Vodafone a buy?

I believe Vodafone will continue to offer an attractive dividend income, and may, in time, deliver a decent capital gain from today’s 194p share price.

However, there are two key questions for shareholders:

1. Will the firm’s management sell its 45% stake in Verizon Wireless, which paid a £6.4bn dividend to Vodafone last year and is thought to be worth $100bn?

2. Could Vodafone’s management find a suitable replacement assetfor Verizon Wireless and avoid overpaying for it?

The answer to both of these questions isn’t clear to me, but for now, I’m giving Vodafone CEO Vittorio Colao and his team the benefit of the doubt, and rating Vodafone shares as a buy.

Can you beat the market?

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> Roland owns shares in Vodafone but does not own shares in any of the other companies mentioned in this article. The Motley Fool has recommended Vodafone.