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Tempted by cheap UK shares? 3 questions I’d ask before buying them 

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It’s no coincidence that one of the most traded FTSE 100 stocks is also among the cheapest. I’m talking about the Lloyds share price, which is at sub-26p levels as I write. I make this point not to explore whether we should buy the Lloyds share price, but to underline the attractiveness of cheap UK shares. 

Why are the shares cheap?

If I can buy shares of some of the best known UK companies at lower prices, isn’t it a better deal than buying them at a higher price? Of course it is. But, I think there’s also wisdom to the markets. Maybe there’s a good reason for the share price being low. Consider the Lloyds share price example again. It crashed as the bank paused dividends and has remained at subdued levels for around six months now. This can be seen as a sign of market wisdom. Potential return on the stock has declined, and with that, demand for its shares. Hence, the lower share price. 

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Alternatively, consider the IAG share price, which dropped 30% in a day recently. As my colleague Stuart Blair details in a recent article, this is because of a rights issue and resulting share dilution. That’s the technical reason for a share price drop. It may or may not have anything to do with the company’s fundamentals. Except, that at least in this case it does. IAG, like other airlines, has struggled enormously in the lockdown and the continuing effects of the pandemic. The company is trying hard to stay afloat, and equity dilution is one of the ways adopted. 

My point in citing the example of both LLOY and IAG is that cheap UK shares are that way because of a reason. And before buying them, it’s essential to ask why the price is low. Which brings me to the next point. Share price should ideally be considered not as an absolute but in relation to other stocks. 

How should I compare cheap UK shares?

The price-to-earnings (P/E) or earnings ratio is a useful measure in this regard. Going back to the Lloyds share price example, its P/E is at a huge 64 times right now. By comparison, Natwest has a P/E of 30.6 times. This actually makes the Lloyds share price more expensive than Natwest, which is worth bearing in mind. 

What’s the stock’s future like?

The P/E ratio is also useful in figuring out where the share’s price may be tomorrow. So, for instance, if we consider the earnings ratio as unchanged and have estimated what the company’s earnings will be like in the next year or even three years, then we can easily calculate the price. If this price isn’t any higher than at present or even lower, I don’t see why it should be bought today just because it’s a cheap UK share. I’m much better off buying a far pricier share that will give me returns on capital. And there are plenty of those around.

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Manika Premsingh has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. 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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