Shares in Royal Mail (LSE: RMG) have been on a consistent downward trajectory over the past 12 months. Indeed, since the end of October last year, the stock has fallen 60%, underperforming its index, the FTSE 250, by around 55% excluding dividends.
Year-to-date the stock has fallen approximately 30%, excluding dividends, underperforming the FTSE 250 by 38%.
In my opinion, this time last year the firm was overvalued. In September 2018, the stock was trading at a forward P/E of around 20. I think that’s far too high for a low-margin, low-growth business like Royal Mail. A low- to mid-teens multiple would have been more suitable.
After recent declines, the stock has reached this level. At the time of writing, the Royal Mail share price is trading at a forward P/E of 7.9, falling to 7.5 in 2021, based on the City’s current growth targets. On top of this, the stock is currently trading at only 50% of tangible book value.
Royal Mail’s low valuation is the primary reason why I turned positive on the stock a few months ago. A forward P/E of 7.5 and 50% discount to tangible book value seems too cheap for this business. Granted, the company isn’t growing, but it still dominates the delivery business in the UK and has a growing international arm.
Management has also woken up to the fact the company needs to invest more to generate growth. It’s been a common complaint in recent years the Royal Mail has not been spending enough to drag the business into the 21st century. Instead, the group has prioritised its dividend to shareholders, which has starved the underlying business of cash.
At the end of May, Royal Mail announced it was cutting its dividend as it invests £1.8bn into the postal service over five years. While income investors have been left short-changed, I think this is the right decision for the business in the long term. And if the extra investment can help Royal Mail return to growth, improve efficiency and profit margins, then I think there’s a good chance the stock could rise substantially from current levels.
A change of direction
At this stage, investor sentiment towards Royal Mail is rock bottom, and it’s unlikely to improve unless the company can prove it’s moving on from past mistakes. A return to growth would be a great start, but this is unlikely to happen overnight. It might be a year before we see any improvement.
With this being the case, while shares in Royal Mail Look cheap at the current price, I don’t think there’s going to be any substantial re-rating of the stock anytime soon. There’s even a chance there could be more pain ahead for investors if its transformation plan struggles to get off the ground.
Put simply, this isn’t a stock for the faint-hearted. If you want to snap up this bargain, you need to be prepared to deal with the volatility that might come with it.
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Rupert Hargreaves owns no share 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.