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Australian equities have taken a beating throughout 2022, with the ASX 200 index down 8.35% year-to-date and the All-Ordinaries index trading just shy of 10% lower than its yearly open, as tightening monetary policy settings from the RBA and growing recession fears lead to a marked discounting of risk-sensitive assets. This sell-off could provide the perfect opportunity for investors to identify good quality companies that have been oversold and undervalued, and that may be some of the outperformers over the next 12-to-18 months. Perhaps even longer.
But how do you identify these opportunities and what exactly is an undervalued stock? There are several metrics that are used by value investors to uncover stocks that have fallen out-of-favour, one of the favourites being the Price-to-Earnings (P/E) ratio. In this article we will define the P/E ratio, how to use it to identify undervalued stocks, and several ASX stocks that are currently trading below their intrinsic value.
What is an Undervalued Stock?
But first, what exactly is an undervalued stock? The term undervalued in financial markets implies that a security is selling in the market at a price below the investment’s estimated intrinsic value. The intrinsic value of a stock can be determined by evaluating a company’s financials. There are several ways to calculate the intrinsic value of a stock, from discounted cash flow analysis through to asset-based valuation. In this article we are going to focus on one of the easier and more common ways to determine intrinsic value, and that is using financial metrics for comparison. In this case, we are going to focus on the P/E ratio.
What is the PE Ratio?
The Price-to-Earnings ratio is used to determine the market value of a stock compared to the company’s earnings. It is essentially a measure of what the market is willing to pay today for a stock based on its past or future earnings. The equation of the P/E ratio is as follows:
Generally, the P/E ratio is used to compare or benchmark one company against others within the same sector, industry or even the wider index. For an example, let’s calculate the P/E ratio for BHP and compare it to some of its major competitors, and the ASX 200 index. BHP reported earnings of $5.83 per share in FY2022 and closed the day priced at $37.91 on September 5th, 2022. This equates to a PE ratio of 37.91/5.83 = 6.5. The PE ratio for the ASX 200, which is a gauge of the largest 200 public companies listed on the Australian Securities Exchange, stands at 27.99 at the time of writing. Given BHP has a P/E ratio that is significantly less than the PE ratio of the ASX 200, it can be described as an undervalued stock. If its P/E ratio was higher, it would then be described as overvalued.
However, a comparison against the broader index doesn’t provide as much valuable insight as comparison against some of BHP’s major competitors. Therefore, it is pertinent to compare the firm against its sector/industry, to see if it is indeed undervalued. The ASX metals and mining industry is trading at a PE ratio of 8.6 – as of September 5th, 2022, with an average multiple of 14.4 over the last three years. With this information we can now identify BHP as undervalued within its own industry and when gauged against the other 199 companies contained within the ASX 200. Now let’s have a look at some other companies within the ASX that are undervalued and could be ones to watch in the year ahead.
Undervalued ASX Stocks for the Watchlist
The following stocks were selected as undervalued stocks as they all have a P/E ratio of less than 15 and have appreciated in value this year. The P/E ratio is just one of many indicators that an investor can use to highlight potential opportunities and unfortunately it can’t predict future price movements. Nevertheless, the companies listed below could present compelling buy opportunities over the next year or so.
1. Woodside Energy (ASX: WDS)
Woodside Energy is an Australian petroleum exploration and production company, that is currently trading at a P/E ratio of 7.41. The firm’s share price has performed admirably this year, surging just shy of 60% year-to-date on the back of a meteoric rise in crude oil prices. Although crude prices have corrected quite substantially lower in recent months, as weak economic growth weighs on consumer demand, the transition away from fossil fuels will likely keep oil prices elevated over the coming years. This will be primarily due to the lack of investment by other firms, and therefore less competition. With net profit climbing over 400% and revenue increasing by 132% in FY2022, Woodside is certainly one to keep on the watchlist and could continue to be an outperformer into 2023 and beyond.
2. Australian Agricultural Company (ASX: AAC)
Australian Agricultural Company owns and operates Australia’s largest cattle herd, producing and selling cattle and beef products. It is trading at a P/E ratio of 8.1, which is significantly below the ASX 200’s multiple of 27.99. The firm’s earnings have surged 201% over the last twelve months and could continue to grow over the year ahead on the back of the fastest acceleration in consumer prices in Australia since the early 1990s. Indeed, the 6.3% increase in the cost of meat and seafood nationally has padded AAC’s margins and will likely continue to do so over the next twelve months.
Expanded Australian CPI Report
3. Genworth Mortgage Insurance (ASX: GMA)
Genworth Mortgage Insurance is a provider of Lenders Mortgage Insurance (LMI) in Australia, trading at a P/E multiple of 7.05. The company recently announced that it had been selected as the exclusive provider of LMI to the Commonwealth Bank of Australia for its CBA and Residential Mortgage for a three-year period starting in January of 2023. With the Reserve Bank of Australia committing to hiking the Official Cash Rate (OCR) in response to elevated levels of inflation, the year ahead could see GMA outperform as mortgage rates and the cost of repayments surge, encouraging lenders to invest in insurance.
4. FSA Group (ASX: FSA)
FSA Group is a provider of debt solutions and direct lending services to individuals in Australia, currently trading at a P/E ratio of 7.8. Personal credit growth reversed its ten-year downtrend in the aftermath of 2020’s coronavirus pandemic and looks set to turn positive over the coming twelve months. Indeed, with the household savings ratio falling to post-pandemic lows and the cost-of-living rising substantially, credit and debt services will probably be utilised more frequently in the near-term, providing a bullish backdrop for FSA’s stock price to gain ground.
5. National Australia Bank (ASX: NAB)
National Australia Bank is one of the four largest financial institutions in Australia in terms of market capitalization, earnings and customers. It’s P/E ratio is 14.86, making it undervalued in comparison to the ASX 200’s multiple of 27.99. The fundamental backdrop of rising interest rates is relatively bullish for the banking sector in general, as it gives institutions the opportunity to lift mortgage rates. At the same time, banks can delay lifting term deposit rates ensuring that they pad their margins as much as possible. With the RBA signalling future rate increases, NAB will certainly be one to keep on the radar.
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Although the immediate months ahead will probably prove rather bumpy for global equity markets, there are still plenty of opportunities for traders to take advantage of, on the long and short side. You can trade the companies listed above and others listed on the ASX with Vantage Markets via CFDs! Open an account and trade Vantage ASX Share CFDs in both long and short directions at 5:1 leverage.
