How can one build wealth in the stock market? Ultimately most strategies boil down to much the same thing: buying shares for less than they actually turn out to be worth. I have been applying that approach in my hunt for UK stocks I can add to my portfolio.
Investing legend Warren Buffett uses such a strategy. He tries to buy stakes in what he sees as great businesses that sell for less than what he thinks they are really worth, based on the business’s long-term prospects. I think I can use such an approach now when hunting for shares that are deeply discounted.
One way to value shares is using a price-to-earnings (P/E) ratio. For example, at the moment, British American Tobacco has a single-digit P/E ratio of 9. That looks cheap to me and I continue to hold the shares in my portfolio.
A P/E ratio can have shortcomings as a valuation tool, though. BAT has large debt and its earnings could fall as cigarette sales decline. Yet neither of those important factors is obvious from the P/E ratio.
So when using that ratio, I also consider what a company’s future earnings are likely to be. That might help me uncover some bargain UK stocks.
Take JD Sports, for example. Its current P/E ratio of 13 looks attractive to me for a business of its quality.
But I reckon the retailer with its proven business model ought to be able to grow earnings in future. It expects headline profit before tax and exceptional items for its current financial year to top £1bn. It briefed investors today that it is targeting annual cash generation from operating activities of £1bn over the next five years.
JD Sports could disappoint me, though. For example, a recession might hurt sales. The further one projects into the future, the more challenging it can be to estimate the financial performance of a company.
But if profits can indeed get larger in future, I think the current JD Sports share price is markedly cheaper than what I see as its long-term value.
Hunting for cheap shares to buy
That is how I look for UK stocks selling at a discount. I consider how their current valuation compares to what I expect they will be able to earn in future by way of profits.
How do I know the current valuation? First I look at market capitalisation. But that only tells part of the story. A company may have large debt like Vodafone or a sizeable cash pile relative to its market capitalisation, as seen at ITM Power. So I also consider a company’s net debt (typically shown on its balance sheet) in conjunction with its market capitalisation.
Understanding a company’s current valuation is the easy part of this process, as there is hard data available. More challenging is trying to estimate a company’s future profits. Like Buffett, I therefore prefer to invest with a sizeable margin of safety. That involves buying UK stocks I think are selling not only slightly cheaper than their value, but instead at a deep discount to it.