A popular way to find cheap shares is to use the price-to-earnings ratio (P/E) ratio. It divides a company’s share price by its earnings per share (EPS), to come up with a way of valuing the stock.
This is best illustrated by an example.
A tale of two banks
For the four quarters to 30 September 2023, HSBC reported EPS of £1.09, compared to 34.7p for Barclays. At first sight, this suggests HSBC’s shares would make the better investment as the company is more profitable.
But this doesn’t take into account the number of shares in issue. Adjusting for this gives a P/E ratio of 5.5 for HSBC, versus 4.1 for Barclays.
This implies that Barclays offers better value. If they had the same ratios, its shares would be nearly 50p (35%) higher.
The average P/E for the FTSE 100 is 15. Although traditional banks tend to attract lower multiples when compared to, say, technology companies.
However, I already have exposure to the sector through shareholdings in two banks. Therefore, if I had some spare cash to invest, I’d be looking elsewhere for cheap shares.
Big brands
One stock that’s recently caught my eye is Unilever (LSE:ULVR). That’s because it’s trading just 2% above its 52-week low.
I used to own shares in the FTSE 100’s fourth-biggest company. But I sold them at the start of the cost-of-living crisis as I thought consumers would switch to cheaper brands.
However, the company has defied my expectations and a small drop in sales volumes has been more than compensated for by a significant increase in prices.
However, the board at Unilever acknowledges that the performance of the business doesn’t match the strength of its brands. The company’s therefore embarked on a programme of change with an emphasis on growth, increased productivity and simplicity.
Its P/E ratio is currently around 14 — the lowest it’s been since 2018. I think now could be a good time to invest.
However, it’s likely to take a long time for the changes to feed through to its share price so I don’t expect any fireworks immediately.
An alternative
Another stock in the Footsie that appears to offer good value is Scottish Mortgage Investment Trust (LSE:SMT).
It’s an investment company, meaning it’s better to assess its ‘cheapness’ by comparing its market cap with the underlying value of its assets. At the moment, it trades at a discount of 14%.
At the start of 2021, its shares were regularly changing hands for close to its net asset value per share.
But despite claiming to invest only in the “most exceptional growth companies“, it appears to have fallen out of favour. With the current emphasis on artificial intelligence (AI), I’d have thought it would be doing better.
Its three biggest holdings are ASML, Nvidia and Amazon — all of which are embracing the AI revolution. Their stocks have risen 15%, 181% and 61%, respectively, since December 2022.
Some have concerns that it has too many interests in unlisted companies. They can be difficult to liquidate, if cash is required. Also, it’s harder to come up with accurate valuations as an active market for their shares doesn’t exist.
Despite this, I think it’s well positioned to benefit from the renewed interest in technology stocks and I’d take a position if I could.
