Most investors wouldn’t say FTSE 100 shares are expensive right now. However, when I’m assessing shares to buy, only a few of them tick my boxes.
Using near-term metrics like the price-to-earnings (P/E) ratio, most stocks on the FTSE 100 look inexpensive or discounted versus their international counterparts.
While it’s not a perfect comparison, the average P/E ratio for the FTSE 100 is around 13.9 times, while on the S&P 500 it’s 24.6.
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Of course, this also reflects the concentration of growth-oriented stocks on US exchanges, but it’s also illustrative of the poor growth forecasts we’re seeing in the UK.
Investing for growth
I don’t mind investing in companies that have less exciting growth prospects if the dividend makes up for it. However, I’d rather invest in companies that have a strong growth trajectory, and ideally one that’s under-appreciated by the market.
One valuation metric that takes growth into account is the price/earnings-to-growth (PEG) ratio. This is calculated by dividing the P/E ratio by the expected growth rate.
Typically, a PEG ratio of one suggests a company is trading at fair value. Meanwhile, a valuation above one infers the stock is overvalued. Below one suggests a stock is undervalued.
It’s not a perfect valuation metrics, but none are. It relies of analysts forecasts for the coming five years, and these aren’t always correction.
The problem is, it’s not easy to find FTSE 100 stocks with PEG ratios below one. So here are two that do have PEG ratios below one.
Lloyds
Lloyds (LSE:LLOY) may be a surprising addition to this list. But according to data published on various sites, Lloyds is trading with a PEG value of 0.5. That’s slightly lower than my own calculations. But the above PEG ratio is calculated using a consensus of analysts’ estimates.
Lloyds is trading towards the lower end of its 52-week average, driven down by concerns about customer credit defaults in a high interest rate environment and recession forecasts.
However, with UK interest rates set to fall towards the just right ‘Goldilocks’ zone — 2%-3% — and positive hedging arrangements, the medium term could see strong growth.
Part of this would be driven by more than £5bn a year in gross hedging income. This is where banks offset changes in the BoE interest rate by buying fixed-income assets, like bonds, with higher returns.
Rolls-Royce
Rolls-Royce (LSE:RR) is trading with a PEG value of 0.55. That’s despite the share price surging over 200% in the last 12 months.
Amid an improving backdrop for air travel, and stable performance elsewhere in the portfolio, the engineering giant is expected to see a major improvement in earnings per share (EPS).
In a recent announcement, the group said it was targeting an operating profit within the range of £2.5bn-£2.8bn by 2027, with significant progress on margins.
Another shock to the civil aviation — like the pandemic — would undoubtedly hamper the recovery. However, the forecasts remain attractive.
Rolls may also benefit from long-term demand for air travel, which is expected to see more than 40,000 new aircraft enter service over the coming two decades.
