There is a declining number of cheap FTSE 100 shares available as the UK’s largest stock index rises. But I think there are still highly profitable companies trading at attractive valuations.
And as long-term investors, our job is to pick the companies we think will bring us the most wealth over time. I think the best way to do this is to seek out cheap FTSE 100 shares that are undervalued relative to their outlook and earnings.
Profit, profit, profit
For my investing portfolio, profitability is key. It doesn’t matter if you create the best products in the world, really. If they cost you more to sell than you make in margin, you don’t have a business, you have a hobby!
So I look for highly profitable companies that — for whatever reason — are trading as cheap FTSE 100 shares. This is when I swoop in and buy.
The main profit metrics I consider are: return on capital employed (ROCE), return on equity (ROE) and operating margin. Each basically measures the same thing in different ways. That is, how well a business uses the cash it has to make more.
There are quite a few cracking FTSE 100 companies that make big profits according to my checklist. But not many of them are cheap.
Why cheap FTSE 100 shares
Five FTSE 100 companies top this list, according to my research. They are Rightmove, Scottish Mortgage Investment Trust, Polymetal International, Persimmon (LSE:PSN) and Hikma Pharmaceuticals.
Rightmove I like for its incredible market share. But on a price-to-earnings ratio of 32 and dividend yield of 0.46%, I think there could be better cheap FTSE 100 shares to buy.
Scottish Mortgage Investment Trust is the UK’s largest fund — but I disagree with it selling big stakes in Tesla, Amazon and Facebook recently. At a 1.5% yield and P/E of 25 I think I can do better than Hikma right now. And while Polymetal’s numbers are slightly better with a 3% yield, it has an above average P/E compared to the FTSE 100 as a whole.
So in terms of cheap FTSE 100 shares, only housebuilder Persimmon fits the bill for me.
Build up wealth
Boris Johnson has said construction can continue throughout the November 2020 UK lockdown. That’s given the best building firms a big short-term boost and a helpful dose of clarity over next year’s earnings.
Net cash of £828.9m is certainly a strong balance sheet for one of the UK’s largest housebuilders. And with a forward P/E ratio of 12 and promising a 7.8% dividend yield next year, Persimmon hits my cheap FTSE 100 shares sweet spot.
Half-year results for the six months to 30 June 2020 showed a forward order book of £2.5bn, 21% ahead of last year. Former CEO Dave Jenksinon brought back a “modest” 40p per share interim dividend on the back of this sales strength. And Persimmon will pay another 70p interim dividend in December due to recent confidence. New chief executive Dean Finch provides a steady hand on the tiller too, I reckon.
And analysis of the wider market is positive too. Research analysts at City broker Jeffries recently rated the sector “too cheap to ignore”.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. TomRodgers has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Amazon, Facebook, and Tesla. The Motley Fool UK has recommended Hikma Pharmaceuticals and Rightmove and recommends the following options: short January 2022 $1940 calls on Amazon and long January 2022 $1920 calls on Amazon. 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.