One way I use to value stocks is the price-to-earnings (P/E) ratio. By using a benchmark fair value figure of 10, I can get a quick sanity check if a company’s potentially undervalued. So when I spotted a FTSE 100 stock with a P/E ratio of under 4, it naturally got me curious to dig deeper.
Recent results
The company’s Centrica (LSE:CNA). The stock’s down 21% over the past year, hitting fresh 52-week lows less than a month back.
The owner of British Gas has struggled so far this year, with the H1 2024 results showing a sharp fall in profit. Profit before tax dropped from £2.07bn a year back to £1.1bn, with adjusted operating profit falling by a similar amount from £2.08bn to £1.04bn.
The disappointing figures were blamed on a few factors, including “no repeat of one-off cost recoveries in British Gas Energy” for this period.
It also flagged a “more normalised external environment”, with lower commodity prices. However, when looking forward the management team’s optimistic, especially due to “the investments [being made] in… data capabilities, product innovation and customer service”.
Understanding the ratio
The P/E ratio focuses on two factors, the current earnings per share and the share price. With the drop in profits, the earnings per share has fallen from 73p this time last year to 25.1p. This acts to push up the P/E ratio. However, the sharp dip in the share price over the same period has acted to partially offset this, keeping the ratio at a low level.
Such a low ratio could indicate a couple of things to me. Firstly, it could be that the stock genuinely is undervalued. From here, if the earnings stay the same, I’d expect the share price to rally in order to get the ratio to a fairer value in the coming couple of years. The extent of the gains could be large. If the earnings per share stay the same and the stock doubles in value, the ratio would still only be close to 8!
The other implication is that people simply don’t want to own the stock. If enough investors think that profits will continue to dip, the share price will keep tumbling. Put another way, the ratio might be low because no value buyers think that it’s worth investing.
The bigger picture
As a risk, I should note that the P/E ratio is just one snippet of information that I should use when thinking about buying a stock. Yet in this case, I do think it offers me a good insight.
The latest results don’t flag up anything material that I think will be a long-term problem for the company. The sector (utilities) is one that has a proven track record. It’s also a defensive play that I can use to try and protect the rest of my portfolio from a stock market crash.
Therefore, when I put all of this together, I’m seriously thinking about buying some Centrica shares as a value play for my portfolio.
This post was originally published on Motley Fool
