In an attempt to build wealth, some people consider buy-to-let properties. They can be hugely rewarding, but being a landlord can also involve hard work and often requires a big lump sum upfront. My own approach, by contrast, is investing in UK stocks with whatever spare money I have. That does not require a large lump sum to start, nor does it take lots of hard work managing a property.
But how do I decide what sorts of shares to buy?
Hunting for cheap UK stocks
What makes a share cheap? Is it cheaper if it sells for pennies than for pounds? Not necessarily.
In the case of a stock priced in pennies, yes, the price per share is lower. But cheapness is about value not price. A share may cost £20, £20 or £50, but still be good value based on the stake it represents in the future financial prospects of a company. Conversely, a share selling for just a few pennies could still be overpriced when considering the long-term commercial outlook of the business.
So when looking for UK stocks I can buy with the hope of building my wealth, I look for a mismatch between what I see as the current valuation of a company’s shares and its long-term value.
Putting theory into practice
Let me share an example. Currently, shares in retailer J Sainsbury sell for around £2.40 each. But knowing a company’s share price is only one part of understanding its valuation — investors also need to know how many shares it has in circulation. Its market capitalisation is the share price multiplied by the number of shares.
In the case of J Sainsbury, that is around £5.7bn. The retailer announced today that it expects full-year profits to come in at the upper end of a range of £630m-£690m. If the company earns £690m, then its price-to-earnings (P/E) ratio will be 8. That seems cheap to me.
But a low P/E ratio on its own does not always mean a share is cheap. I need to look at other factors too, such as what debt a company has (it may not affect earnings, but will need to be repaid at some point) and also whether the business looks likely to maintain or grow its profits. Otherwise, a share may be what is known as a value trap. That is one that looks cheap but, as its business performance deteriorates, may turn out to be bad value in the end.
Building a portfolio
Using this approach, I can try to build my wealth by building a portfolio of UK stocks I think offer me good value. To do that, I would first try to find companies I felt had excellent business prospects, not only for the short term but also on a longer timeframe.
I would then consider whether the current share price offers me great value. If not, I would do nothing. But if the share price was cheap enough that I felt I was getting great value, I would consider adding the shares to my portfolio.
The post Forget buy-to-let! I’d invest in cheap UK stocks to build wealth appeared first on The Motley Fool UK.
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C Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended J Sainsbury Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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