Looking at some leading UK shares like M&G, Rio Tinto and JD Sports, they seem like real bargains to me.
But the first two of those three have actually fallen in price over the past year (JD Sports has risen 29% in that period). So, are leading British shares bargains – or could they be value traps?
Understanding value traps
Even for a novice investor, understanding the concept of a ‘value trap’ is very important.
It’s exactly what it sounds like. It looks like a bargain offering good value while ultimately turning out to be anything but that, sadly.
It is easier to identify one with the benefit of hindsight. Looking forward, the indicators of what might be a value trap can also be the indicators of a real bargain.
Take British American Tobacco as an example. The company has growing revenues, huge free cash flows and has increased its dividend annually for decades. With a price-to-earnings (P/E) ratio of under 9 and a dividend yield of 8.6%, the FTSE 100 share looks like a bargain to me.
Yet the shares have fallen 29% in five years. The low P/E ratio is based on earnings that are mostly generated by selling cigarettes, an industry in long-term structural decline. British American might be able to replace those earnings by ramping up its non-cigarette business. Then again, it might not.
A decade from today, the current share price may look like a bargain – or an obvious value trap with the benefit of hindsight.
Understanding share valuation
There are some specific reasons why UK shares look cheaper than those from some other markets such as the US.
Investors are nervous about the health of the British economy. The London market has been struggling to attract global capital in the way New York has been doing. The UK lacks depth in some racy growth sectors that tend to have expensive-looking valuations, unlike the US.
But ultimately, I think share valuation is a fairly straightforward concept in principle, if not always in practice. I look at the excess cash I expect a company to throw off in future, minus any debt it has. I discount that for the cost of tying up money over the long term.
If the final figure is still significantly above a company’s current price, it could offer me good value.
Hunting for value
The approach I describe is known as the discounted cash flow model. Other investors have their own valuation techniques.
Whatever approach one uses, though, I think it is possible to account for the current and possible future state of the British economy. Just because a company faces medium-term challenges like high inflation and weak consumer sentiment does not mean it is uninvestable.
Instead, I see those as data points to factor in when valuing a company. No doubt some shares are value traps. But even allowing for a weak economy and seemingly widespread investor nervousness, I think that some other stocks really are bargains right now relative to their long-term growth prospects.
JD Sports is just one example that I have been buying for my portfolio this year. As a long-term investor, I remain in buying mode!
This post was originally published on Motley Fool
