If you’re going hunting for discount UK value stocks listed on the London Stock Exchange (LSE) that are trading at low share prices, keep in mind that finding the best cheap shares to buy isn’t as simple as some make it out to be.
The problem with judging the value of a stock is that, to a degree, it can be subjective and a matter of opinion. Also, like with anything - sometimes you get what you pay for. Cheap UK stocks aren’t always great, and a great UK stock isn’t always cheap.
We’re going to take a deeper look at Britain’s bargain basement to see how you can try to separate the junk from the diamonds in the rough. This will arm you with the knowledge you need to compare basic info from balance sheets, spot a solid cash flow, and take note of a stock’s dividend yield.
Combining all the valuation tools described later will allow you to build yourself an investing strategy that uses the right blend of stocks for you and your personal financial circumstances.
They are equity investments trading in stock markets at a share price that’s lower than what the company is believed to be worth.
However, not everyone looks at valuations in the same way. Someone’s undervalued stock, might be another person’s trash.
The two main ways of working out whether a stock is undervalued look like this:
If you’d like to know more about stock valuations, you can read this guide to learn how to value stocks.
There’s no strict value investing formula that all investors subscribe to. But the general idea when it comes to investing involves buying shares that offer ‘value’.
That may sound a little vague, so let’s dive deeper.
Value investing is essentially an investment strategy where you try to find stocks that are currently trading at a share price that appears to be below the stock’s ‘intrinsic value’. So the overarching theme of value investing involves buying shares that you believe the stock market (and other investors) are underestimating. A true underdog story.
Determining a stock’s intrinsic value can be a whole other can of worms that leaves plenty of room for interpretation. Two of the most popular methods involve using either fundamental analysis (looking at financial statements, competitors, and markets) or technical analysis (which is more focused on price trends and patterns).
Sometimes, markets are inefficient. Stock markets (and investors) can also be irrational - and that can occur more frequently during certain periods.
Value investors look to take advantage of these overreactions or underpricing of investments. The idea is that if you hold onto these under-loved shares for long enough, they’ll provide value by gaining back the discount you received by purchasing the stock at a lower price when it was out of favour.
It’s what Warren Buffett drooled over when he first found his feet in the stock market, following in the footsteps of his mentors. He’s one of the most famous value investors out there.
Last year, Berkshire Hathaway’s annual performance blew the Nasdaq, S&P 500 and Russell indexes out of the water. While they all finished in the red, his holding company ended 2022 in the green.
Buffett’s type of investment strategy will usually involve a strong stomach for potential losses, a willingness to move against the crowd, and a long-term investing mindset. What plenty of investors tend to gloss over with Buffett is that over 99% of his net worth was earned after his 50th birthday (even though he was a stockbroker at just 21). Now that’s some patience.
So while value investing can sound reasonable enough in theory, putting your faith into underperforming stocks and shares can really test your mettle as an investor.
There’s no single method to find cheap UK shares to buy.
But that means there’s plenty of opportunity to sift through all sorts of large and small UK businesses when hunting for value.
One of the best ways to find UK value stocks from a list of LSE shares is to first develop your own investment strategy. This will also involve having a deep understanding of your own goals, time horizon, and appetite for risk.
The next step is to learn some basic valuation metrics. Grasping these measurements will allow you to better compare various value stocks and see how cheap UK stocks within the same sectors stack up against each other.
When it comes to value stocks, there are general thresholds that once hit, might mean a stock’s considered ‘cheap’. But bear in mind, these metrics always need to be considered alongside the bigger picture and the rest of the company's outlook and performance.
Here’s an overview of some of the major valuation metrics that investors will use when trying to find the best UK value stocks to buy. For a more in-depth guide, you can check out our article on rationalising ratios.
A company’s ‘market capitalisation’ (or market cap for short) lets you know the total market value of a firm’s outstanding shares.
Comparing companies of similar market caps can be a useful tool when you’re looking for value stocks. This will stop you from potentially making the mistake of comparing a small cap with a large cap firm. It’s not apples to apples. Companies of very different sizes tend to operate quite differently when it comes to growth and performance targets.
Because of that, market cap is a key valuation metric to wrap your head around. Plenty of other metrics rely on it in their own calculations.
Price-to-earnings ratio or ‘P/E’ (not to be confused with physical education) is a major tool that investors can use to get an idea about a stock’s value.
There are a few versions of the P/E ratio, but the one on your Freetrade app is what’s known as a ‘trailing P/E ratio’. The lower this ratio, the more undervalued a stock could be and vice versa. But remember, the stock may be valued lowly for good reason.
Essentially, this ratio shows you how much a share costs compared to the company’s profit over the last year (that’s why it’s a trailing metric). It’s a useful one for your valuation toolkit because it’s relatively easy to understand and calculate.
The calculation goes like this:
P/E ratio = Share price / Earnings per share
On top of that, it’s an applicable metric for most industries (apart from certain technology stocks because they tend to be unprofitable for large periods and typically trade at much higher P/E ratios than more traditional companies) making it fairly universally useful. That said, you shouldn’t rely on the price-to-earnings ratio as your be-all and end-all. Price and profit don’t paint the whole picture.
The price-to-book (P/B) ratio is used to measure how the share price of a stock stacks up against its book value per share (BVPS).
BVPS is worked out by dividing a firm’s common equity (the difference between assets and liabilities on the balance sheet) by the number of shares outstanding.
The calculation goes like this:
P/B ratio = Share price / BVPS
Using the P/B ratio is useful for evaluating a volatile stock with legitimate assets on its balance sheet and gives you a snapshot of today’s value, rather than making future projections or looking too far into the past.
A low P/B ratio under 1 could signal value. Yet, it could also highlight a fundamental problem with the stock since investor confidence must be quite low if the market isn’t pricing the stock to be worth at least the same value as the assets it owns.
Earnings per share (EPS) shows you how much money a stock is making compared to the number of shares available. It’s a great tool for assessing how profitable a company is on a per-share basis.
Here’s what the basic formula looks like:
EPS = (Profit - Dividends) ÷ Number of shares outstanding
You can compare the EPS to the share price and basically see how much you’re paying for the profit being generated. Although this can show you if you’re paying a ‘cheap’ price for profit, it’s not a foolproof system.
These aren’t necessarily the best UK value stocks to buy now, but they are options which have been popular with other Freetrade investors.
This isn’t a recommendation to buy any of these UK value stocks listed below, the idea is simply to show you popular examples of companies that could be deemed to be good value by some British investors.
So, check out this selection describing some of the most popular LSE-listed UK value stocks available to buy, based on Freetrade data at the time of writing, December 2022.
To give you an idea about ratios, here are some estimated thresholds to be aware of. Depending on the industry, P/E ratios under 20-25 can be attractive to value investors. For a P/B ratio, close to 1 can be useful for spotting good value, and with EPS, the higher the better, though a positive growth trend year-on-year for EPS can be a good sign if other metrics are pointing towards the stock being undervalued.
Source: Freetrade app, 22 December 2022.
Ideally, because you’d hope that if the market is currently undervaluing the stock - it should eventually rise in value to meet its ‘true’ or ‘fair’ valuation.
The difference between the current price and what investors believe the price should be, could ultimately become your capital gain. And there are some significant changes coming in the 2022/23 tax year.
The good news is, stocks and shares ISA rules remain unchanged. It’s important to make the most of any potential returns by using a tax wrapper like a stocks and shares ISA or a SIPP to protect your portfolio from an increasing tax burden.
Even if an undervalued UK stock doesn’t reach its full potential, making some progress or earning consistent dividends can generate a return on your portfolio. Why let that return be sliced by declining allowances? We’ve written plenty more about how to make the most of dividends in your stocks and shares ISA.
That said, there’s no guarantee that any UK value stocks, or those based abroad for that matter, will ever rise to meet what some believe the stock should be worth.
The only way isn’t up. Even the best UK value stocks can trade sideways or downwards.
They definitely can be. Using value investing as part of your investment strategy and basing your investment decisions on sound fundamentals can be a useful approach. Valuation metrics, like those we touched on above, are a sensible way to get a better understanding of a stock before you put your money into it. Your Freetrade Standard plan and Freetrade Plus plan gives you plenty of those too, including P/E, P/B, market capitalisation, dividend yield, and PEG.
Just don’t forget that cheap shares don’t always go up in price. If you only concentrate on this one attribute, you could miss out on some excellent growth stocks and LSE shares that don’t necessarily fit that ‘good-value’ glove.
You might also want to look at international stock markets and think about buying US shares, or maybe just consider cheap shares that aren’t UK value stocks. The world is your oyster, and building a broad portfolio is key to ensuring you’re benefiting from diversification. And if you’re ready to start building that up, check out our guide on how to start investing.
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