The FTSE 100 has soared since a nadir in late summer/early autumn. But the recovery to an all-time high hasn’t been an equal one. Resource and energy stocks have surged. Meanwhile stocks in sectors such a housebuilding, banking, retail and aviation have suffered.
The thing is, many stocks are cheap for a reason. So, can I still find undervalued picks on the FTSE 100?
Finding cheap stocks
The current average price-to-earnings (P/E) of the FTSE 100 around 14. A lower P/E suggests that a stock is either undervalued or that it’s cheap for a reason. Meanwhile, a higher P/E suggests a company has high growth potential, or that it’s becoming expensive.
So, how can I find bargain shares on the index?
Well, I need to do my research. I can use the P/E ratio, as well as other metrics such as the enterprise-value-to-EBITDA ratio, and compare these figures among peers in the same sector. This will help me develop an idea of relative valuation.
The discounted cash flow model can offer a better way to understand a stock’s value than these near-term valuation metrics. However, it does require me to make estimates about future cash flows and this can be challenging and potentially misleading.
Cheap sectors
Unsurprisingly, the cheapest sectors are the ones that are experiencing the most challenges right now.
Housebuilders have seen billions wiped off their share prices over the last year. That’s because interest rates have been rising and this increases the cost of borrowing. Demand for new homes is down while cost inflation is pushing building costs up.
As such, several housebuilders are trading with very low P/E ratios. Persimmon, for example, trades with a P/E of just 5.8. It’s tempting to buy here, but I’m holding off for a while.
Then there’s the banks. Now, banks are cyclical stocks. This means they often reflect the health of the economy. As such, with the UK forecast to experience a recession in 2023, we’d expect banks to perform poorly. This is broadly reflected in share prices. Despite recent surges, UK-focused companies are fairly flat over 12 months.
What am I buying?
Despite concerns about the impact of recessions on bad debt, I’m still buying bank stocks. That’s because higher interest rates are pushing revenues up.
Banks are even earning more money from deposits held with the Bank of England. As such, I’m actually expecting to see profits push upwards as the year goes on, because of this, and despite the recessionary environment.
Lloyds is my top pick. It has a P/E ratio of around seven and discounted cash flow models suggest the stock is undervalued by around 50%.
There are obviously concerns due to its focus on the UK mortgage sector — around 70% of income comes from the UK mortgage market — as inflation, recession and rising rates are a recipe for bad debt.
However, I feel the risks are overplayed. I’m buying more Lloyds stock now for a long-term recovery.
