As a market capitalisation weighted index, price changes in the FTSE 100 (FTSEINDICES: FTSE)Â are impacted far more severely by movements in the share prices of stocks with larger market caps. Indeed, a large movement in a small company has nothing like the same impact on the index as a small movement in a large stock, so when deciding whether the FTSE 100 is cheap or expensive, it can be far more useful to focus on the stocks that matter.
In the FTSE 100’s case, three stocks dominate: Shell (LSE: RDSB), HSBC (LSE: HSBA) and BP (LSE: BP) (NYSE: BP.US). They are the three biggest companies by market cap on the FTSE 100 and the best news is that they all appear to be undervalued right now. This means that the FTSE 100 could go much higher.
Shell
With its two classes of shares combined, Shell is the largest company by market cap in the FTSE 100. Indeed, despite future growth prospects being somewhat muted, Shell offers good value at current levels, with shares in the company currently trading on a price to earnings (P/E) ratio of just 11.4. This is considerably below the FTSE 100’s P/E of 13.9 and shows that Shell has the potential for upside, thereby helping the FTSE 100 to move higher.
Of course, the fact that the oil price has fallen back to $100 after its recent spike is not great news for Shell and could dampen short-term sentiment. Despite this, Shell’s strong cash flow and focus on returning cash to shareholders could see shares in the company experience increased demand going forward, thereby helping to narrow the current valuation gap versus the index.
HSBC
As with the wider banking sector, HSBC looks cheap at current price levels. Indeed, despite remaining profitable throughout the credit crunch HSBC trades on a P/E of just 11.1, while its price to book ratio is very low at 1.06. Furthermore, HSBC offers strong growth potential, with earnings set to increase by 9% in each of the next two years as improvements in the outlook for the UK economy continue to aid the banking recovery. In addition, HSBC could see sentiment pick up as Chinese data continues to improve — recent PMI and GDP growth figures suggest that the world’s second-largest economy could be back on-track. As such, HSBC shares could go higher and help the FTSE 100 surpass 7,000 points.
BP
Although far smaller now that it was before the Deepwater Horizon tragedy in 2010, BP is still the third biggest FTSE 100 listed stock by market cap. As with Shell and HSBC, it offers great value for money right now through it having a P/E ratio of just 10.1. Clearly, there is likely to be above-average volatility going forward, with BP continuing to turn itself around following the oil spill and, as with Shell, a lower oil price may not be positive news in the short run. However, investors are still likely to be attracted to BP’s yield of 4.7%, as well as its strong dividend per share growth rate of 5.4% that is pencilled in for next year. This could help to push shares higher and aid the FTSE 100 in its quest to break the 7,000 barrier.