How to Find Cheap Stocks UK - 4 Important Financial Ratios to Know
Many investors would have heard the phrase ‘buy low, sell high.’ However, identifying the best cheap stocks to buy now is far easier said than done. A low share price or cheap stock may be a good place to buy low or it may keep on going lower.
Judging whether a stock is cheap or not can be a difficult process. However, there are some valuation metrics that investors use to help in their decision-making making which we explore in this ‘How to Find Cheap Stocks UK’ article.
What are Cheap Stocks UK
Cheap UK stocks are companies whose share prices are trading at a historically low level relative to what they should be worth. Why would a stock become cheap? A good company with strong long-term prospects may be hit by some bad news which can cause its share price to fall making the stock cheap to some investors.
Identifying what is a cheap stock or not can be subjective. This is why investors try to standardise the analysis of a company’s worth by using different types of valuation metrics. To identify cheap stocks, some investors would use value investing techniques.
Value investing is a way of identifying cheap stocks that are trading at a discount to their intrinsic value. The most famous value investor is Warren Buffett who tries to invest in companies that are trading lower than what they should be worth.
How to Identify Cheap Stocks to Buy Now UK
There are hundreds, if not thousands of different financial ratios that investors use to identify if a company is undervalued and considered a cheap stock to buy. Below are a few common metrics used to identify the cheapest stocks UK.
1. Earnings per share (EPS)
Earnings per share (EPS) measures how much money a company is earning relative to the number of shares available. It is calculated by dividing a company’s profit by its outstanding shares.
EPS = (Net Income – Dividends) / Outstanding Shares
The EPS is a common way of estimating the worth of a company as it is directly related to its level of profitability. A higher EPS indicates more value because investors are willing to pay more for a company’s shares if they believe it is making a high level of profit relative to its share price.
As with most financial metrics, the EPS is more valuable when comparing it to other companies within the same stock sector or industry.
2. Price to Earnings (P/E) Ratio
The price-earnings ratio is calculated by dividing the company’s share price by its earnings per share (EPS). The ratio helps determine whether a stock is undervalued or not by comparing the company’s stock price to the profit it is making.
A high PE ratio could mean that the company is overvalued, whereas a low PE ratio could mean it is undervalued. However, the P/E ratio by itself doesn’t paint the full picture. It is more effective to compare the price-earnings ratio of different companies in the same sector.
For example, comparing the price-earnings ratio of UK supermarkets can provide more understanding of which ones are underperforming or overperforming.
There are two types of P/E ratios – forward and trailing.
3. Price to Sales (P/S) Ratio
The price to sales (P/S) ratio is typically calculated by dividing a company’s market capitalisation by its revenue. Effectively, it values a share based on a company’s annual revenue and is useful when comparing the ratio to other companies in the same industry.
4. Price to Book (P/B) Ratio
The price to book (P/B) ratio measures a company’s market cap to its book value. It is calculated by dividing the company’s stock price by its book value per share. Value investors typically like to see a P/B ratio under 1.0 but it is more useful when compared to other companies in the same industry.
How to Invest in UK Stocks
With Admiral Markets, you can invest in UK stocks and ETFs with the following commissions:
- UK stocks – 0.1% of trade value, 1 GBP minimum commission.
You can search for thousands of global stocks and ETFs from 15 of the world's largest stock exchanges from Admiral Markets' web platform and invest in four steps:
- Open an account with Admiral Markets.
- Click on Trade on one of your live or demo trading accounts to open the web platform.
- Search for your symbol at the top of the search window.
- Click Create New Order in the bottom window to open an investing ticket to input your trade size, stop loss and take profit level.
3 Cheap Stocks UK to Watch
It's important to remember that every investor has a different meaning of what is cheap or not. A momentum investor may buy at high prices that a long-term value investor would say is too high. Therefore, identify your investing style first to create your strategy. Below are a few UK shares to watch this year.
1. Barclays (BARC)
Barclays is a financial services company that operates all around the world and offers retail banking, credit, wholesale, investing banking, and wealth management services. Founded in 1690, it has 87,400 employees and a market cap of £24.1 billion.
Its current price-to-earnings ratio of 4.8x is below the industry average of 7.4x suggesting some value based on this metric. When taking the company’s forecasted earnings growth, the stock is trading below its fair price-to-earnings ratio of 7.4x.
Its current price-to-book ratio is 0.4x with a price-to-sales ratio of 1x. The stock price has struggled this year so far due to souring sentiment on banking stocks due to regulators taking control of US-based Silicon Valley Bank.
2. Rolls-Royce Holdings (RR)
Founded in 1884, Rolls-Royce Holdings has 41,800 employees with a market cap of £13.0 billion. The company has four segments: civil aerospace, power systems, defense, and new markets. This broadly covers the development and manufacturing of aero engines for larger aircraft, the sale of engines to the military and submarine nuclear power plants, and more.
The company’s price-to-sales ratio is 1x which is lower than the average of its peers at 2.1x and lower than the European Aerospace & Defence Industry average of 1.4x. The industry is forecasted to grow 7.2% with Rolls-Royce forecasted to grow 5.2% during the same time.
The Rolls-Royce share price collapsed more than 90% from its record high in 2014 to its pandemic low in 2020. Since then, the stock has rallied more than 300% higher but headwinds remain for the UK stock market and airline industry due to energy price volatility.
3. Marks and Spencer (MKS)
Marks and Spencer is a multinational British retailer that specialises in selling food products, clothing, and home products. It was founded in 1884 and has more than 78,000 employees and a market cap of £3.1 billion.
Its current price-to-earnings ratio of 9.8x is below the industry average of 13.3x. When considering the company’s forecasted earnings growth it is below its fair price-earnings ratio of 13.8x.
However, while these valuation metrics suggest an undervalued stock relative to the industry when analysing its future cash flow using the discounted cash flow model its fair value is £0.91 making the stock overvalued on this metric.
Conclusion: Identifying Cheap Shares UK
Analysing the long-term price direction of a stock can be challenging. It is important to diversify an investment portfolio and keep the risk small to manage both winning and losing investments appropriately. Valuation-based metrics are just one way to analyse a company’s worth.
Most investors tend to use a combination of analysis techniques to analyse a stock. This includes a fundamental analysis of a company such as analysing sales, product developments and sector strength. There is also the macroeconomic environment to take into consideration as well such as the overall sentiment towards global economic growth.
Investors can also use technical analysis as another tool to analyse a stock. This involves studying historical price activity using chart patterns and technical indicators to understand the relationship between buying and selling activity.
A good way to start is to use a demo trading account. This allows you to practice different analysis techniques and strategies in a virtual trading environment until you are ready to go live.
Continue Reading:
- 10 Best Penny Stocks UK
- 4 Best Shares to Buy
- Top 10 UK Shares to Watch
- How to Find the Best Stocks for Day Trading
FAQs on the Cheap Stocks UK
How do I pick a cheap stock?
Picking a cheap stock is difficult because it can be subjective. Some investors use valuation metrics to determine the worth of a company. This includes ratios such as the price-earnings ratio, price-to-book ratio, and others.
What are cheap stocks UK?
Cheap stocks are stocks that are trading at a price lower than its fair value. Another term for cheap stocks is undervalued stocks. Value investors try to identify stocks that are trading below their intrinsic value.
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