Towards the end of July, I noted that long-term investors might benefit from buying Royal Mail (LSE: RMG) shares, considering the stock’s valuation.
This turned out to be a well-timed piece of advice. Since the article was published, the shares have risen in value by around 30%.
And I think there could be more to come. Despite this positive performance, the stock continues to trade as a deep discount to its intrinsic value.
Today, I’m going to explain why I believe Royal Mail shares could be heading back to 300p in the medium term.
Royal Mail shares on offer
Shares in the company jumped after it predicted outstanding parcel deliveries in 2020 alongside its first-half results. The group’s primary UK division recorded a one-third growth in parcel revenue in the five months ending 30 August.
Unfortunately, this growth wasn’t enough to offset increased coronavirus costs and declining letter volumes. Still, thanks to the increase in parcel revenue, management now expects sales at its UK division to hit £75m-£150m in 2020-21. Previously, management was forecasting an overall decline of £250m.
In addition to this growth, Royal Mail’s overseas parcels subsidiary, GLS, is expected to report revenue growth of 10-14% this financial year.
All in all, the company has benefited significantly from the increase in parcel volumes this year, and this trend looks set to continue. Royal Mail shares also look set to benefit as a result.
2020 has been somewhat of an inflection year for the e-commerce market. Internet sales as a percentage of total retail sales jumped to more than 30% in May from 20% at the beginning of the year.
This was a big leap, but it shows just how small this market remains relative to the brick-and-mortar sector. If online sales as a percentage of total retail sales continue to trend higher in the years ahead, Royal Mail could reap significant rewards.
Undervalued growth
As such, while the business is facing some challenges, I’m optimistic about the outlook for the business in the long run. If management can successfully restructure the company and reduce costs, parcel revenue growth should offset declines in other divisions. The group’s international business also provides a much-needed income stream.
Even after its recent performance, the stock looks cheap compared to its potential. Royal Mail shares are currently changing hands at a price-to-book (P/B) ratio of just 0.5. That indicates the stock offers a wide margin of safety at current levels.
The book value is around 460p. I think it’s unlikely the company will return to this level, but 300p doesn’t seem too unrealistic. Investor sentiment could dramatically improve if Royal Mail can restore its coveted dividend and return to profitability in 2021.
Therefore, now could be the perfect time to add the stock to a diversified portfolio. The business may continue to face headwinds in the short term. Still, in the long run, I’m optimistic about the outlook for Royal Mail shares, considering its valuation and growth potential.
