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.
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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.
