With a P/E ratio of just 3.76, is this FTSE 100 stock an undervalued stock?
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Another method I use to value stocks is the price-to-earnings (P/E) ratio. Using a fair value benchmark of 10, I can get a quick sanity check if the company is likely to be undervalued. So when I see a FTSE 100 stock with a P/E ratio of less than 4, made me curious to dig deeper.
Latest results
For the company Centrica (LSE: CNA). The stock is down 21% over the past year, hitting a 52-week low less than a month after it returned.
Owner British Gas has struggled so far this year, with H1 2024 results showing a sharp drop in profits. Profit before tax fell from £2.07bn in the year back to £1.1bn, adjusted operating profit fell by the same amount from £2.08bn to £1.04bn.
The disappointing figures were blamed on several factors, including “not a single cost recovery for British Gas Energy” at this time.
It also flagged a “normal outer space”with low commodity prices. However, when I look forward to the management team hope, mainly because “an investment [being made] in… data skills, product innovation and customer service”.
Understanding the ratio
The P/E ratio focuses on two factors, current earnings per share and share price. In line with the fall in profits, earnings per share fell from 73p this time last year to 25.1p. This helps increase the P/E ratio. However, the sharp plunge in the share price at the same time served to reduce this slightly, keeping the ratio at a low level.
A rating that low would indicate a few things to me. First, the stock may be genuinely undervalued. From here, if earnings remain the same, I would expect the share price to converge to fair value over the next few years. The level of benefits can be huge. If earnings per share remain the same and the stock multiplies in value, the ratio will still be close to 8!
Another implication is that people don't want to own stocks. If enough investors think that profits will continue to sink, the share price will continue to fall. Put another way, the rate may be low because no buyers think it's worth the investment.
Big picture
As with risk, I should note that the P/E ratio is just one piece of information to use when thinking about buying a stock. But this time, I think it gives me a good insight.
Recent results do not reveal anything significant that I think will be a long-term problem for the company. The sector (utilities) is one with a proven track record. It's also a defensive play that I can use to try to protect the rest of my portfolio from a stock market crash.
So, putting all this together, I'm seriously considering buying Centrica shares as a value play for my portfolio.
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