No matter how attractive a company is, if I pay too much for its shares then I could still make a loss. That is why I do not just try to find attractive businesses to invest in – I also consider what value I can get based on the current share price. Here is my approach to finding cheap UK shares I can add to my portfolio.
Initial focus on business fundamentals
To start with, I ignore the share price and look at the quality of the business in question. As a shareholder, I want to own a stake in companies that have compelling long-term economic prospects.
What does such a company look like? It will typically operate in a market where there is expected to be ongoing customer demand. So, for example, I expect customers will still buy electricity a decade from now. That could be good for a power firm such as SSE. But the growth of streaming means I am less confident that cinema-going will stay popular, which could be bad for a company like Cineworld.
I also prefer a company to operate in a market that already has proven demand. So, for example, the size of the end market for ITM Power remains far less clear to me than that of the domestic gas market served by DCC.
If a proven market seems to have good ongoing prospects, I then look for a company with a sustainable competitive advantage in it. That could come from a proprietary recipe it owns, such as Irn Bru maker A G Barr, an installed network like that of National Grid, or a well-developed brand like that of Greggs, for example. Such a competitive advantage matters to me because it can sustain a company’s profitability.
Price and value
Only once I have found such a company do I then consider its share price.
I do this as part of valuing the company. I try to decide what I think the company’s business prospects mean it is worth, then compare that to its current share price. If the shares sell at a sizeable discount to what I think the company is worth, I may regard them as good value.
Cheap UK shares and balance sheets
But before I buy a share I also examine the company’s balance sheet. After all, it might have a profitable business but be laden with expensive debt.
Paying that debt off could mean that even if the valuation is cheap relative to the company’s ability to earn profits, the shares are not attractive to me as an investor. Cineworld is an example of this. With its large portfolio of cinemas, I reckon this company could earn sizeable profits in future. Its pre-pandemic 2019 earnings per share were around 10p per share. If it can get back to that level, the current share price suggests a price-to-earnings ratio just above 3.
That sounds very cheap. But crucially, Cineworld has net debt of £6.7bn – more than 14 times its stock market capitalisation. So even if the company does see earnings recover to former levels, they could be swallowed up servicing debt.
That is why I try to buy companies with a competitive advantage in a durable market, trading at a very attractive valuation even after taking their balance sheets into account.
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Christopher Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended AG Barr. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.