Image source: Getty Images
Assessing whether I have cheap stocks in my hands or not is always quite complicated. Sometimes investors in general are willing to pay a premium for a company over the long term. That can make traditional valuation methods obsolete.
But fortunately, in this case, the company seems undervalued to me based on future earnings forecasts. What I like about this is that it adds a level of security to the investment. But as I will explain, not everything is rosy.
Building wealth
Breedon Group (LSE:BREE) is a leading construction company in the UK and Ireland, providing materials such as concrete and gravel. Its business strategy includes the acquisition of other companies and, recently, an expansion into the United States.
It marked its entry into North America by acquiring BMC Enterprises for $300 million. But right now, 87.2% of its revenue comes from the United Kingdom and 12.6% from Ireland. Only 0.2% is from other parts of the world.
I especially like that the company is asset-backed, meaning it has high levels of tangible assets and resources. That includes cement plants, quarries and asphalt plants.
Why do I consider it cheap?
First, the stock has a price-to-earnings ratio of just 12, as I write. Over the past 10 years, the norm has been more like 27.5. That means there is a potential discount right now of approximately 56%.
However, I also looked at its future earnings potential to get a more solid understanding of its value. Over the next four years, analysts expect a compound annual earnings growth rate of around 5.3%. This is slower than usual and, as the UK economy improves, I expect it to rise to around 10% on average annually over the next decade.
Putting my forecast into a discounted cash flow model, I estimate the company is trading around 33% below its value. However, even if the company only manages to grow its net income by 5% over the next 10 years, it is still undervalued by 7% according to my model.
Expectations and risks
While the company has a healthy 3% dividend yield, over the last 10 years, the stock has only gained 64% in price. That equates to a compound annual growth rate of 5%. Let's compare that to its broader index, the FTSE 250but also to the United States S&P 500, which I consider one of the largest indexed investments in the world. As we can see, Breedon is doing quite well:
But the investment is also subject to quite a bit of volatility. In particular, its market is heavily influenced by broader economic pressures. Housing market downturns can also cause construction companies to do less business. Therefore, I wouldn't want a lot of my money in stocks.
Additionally, since its gross margin and operating margin have been declining for a while, I think we could see the company's earnings take a hit if this is not rectified. Suppliers are raising prices right now, so I understand why Breedon has struggled.
While I don't consider this to be one of the best investments for high returns, it certainly seems good and stable to me, with a promising future. It's on my watchlist, but I won't be investing in it anytime soon.
