Two classic financial indicators that, other things being equal, suggest a stock is undervalued are a low P/E multiple and a high dividend yield, compared to the index average.
Sometimes shares are marked down on low P/E valuations because the market sees a company as being in trouble, and perhaps even at risk of going bust — like Debenhams, for example.
And sometimes high dividends are not sustainable and have to be cut, as many investors in financial companies found out to their cost when the banking crisis hit.
Irresistibly cheap?
Housebuilder Barratt Developments (LSE: BDEV) shares are currently on a forward P/E of only 8.5, which is way below the FTSE 100‘s long-term average of around 14. Forecast dividends yields look very good too at 7.5%, well ahead of the Footsie forecast of 4.7% for this year — and that 4.7% is considerably better than the long-term index average.
Is Barratt at any risk of going bust like Debenhams, or is it heading for a dividend catastrophe like the banks and insurers? In both cases, I’m plumping for a big no.
The fear is that, with Brexit so near (or perhaps so far away — what happens next is anybody’s guess right now), there are threats of a big slowdown in house prices (if not a slump), and the market does appear to be cooling.
A survey by the Royal Institution of Chartered Surveyors (RICS) in March reported the eighth month in a row of declining buyers’ enquiries, with homes in the South East now taking an average of 21.5 weeks to sell. It expects the slowdown to carry on pretty much for the rest of the year, seeing a modest price fall continuing for the next two quarters.
And according to Rightmove, wage rises are edging ahead of house price inflation, which is good news for buyers — but how bad is it for housebuilders?
Worst case
Suppose we really do experience a deep and prolonged slump, and Barratt’s earnings and dividends drop all the way back to 2015 levels. On today’s share price, we’d still be looking at a P/E of 13, and the dividend that year, including the firm’s special payment, would have yielded 4.1%.
You might worry that specials are not reliable, but paying a low ordinary dividend and topping it up from excess cash is pretty much standard in this business. And I like that approach, because it makes it easier for a company to cut back should it have a more important use for the cash in some years, without the emotionally damaging effect that an ordinary dividend cutback could have.
Now, I don’t see any prospect whatsoever of Barratt’s earnings dropping back to 2015 levels, but as a worst-case scenario, even that would be far from a disaster for share valuations.
Housing shortage
Meanwhile, the UK’s housing shortage is so extreme that the charity Shelter has estimated the need for 1.2 million new homes for younger families who can’t afford to buy and are stuck with “expensive and insecure private renting.”
Barratt’s first-half results in February showed sales and profits up yet again, with chief executive David Thomas “confident of delivering a good financial and operational performance in FY19.”
I think the future is rosy for Barratt shareholders.