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3 stocks with over 20% upside potential

An often used proxy for estimating next year’s earnings of a company is to use “consensus earnings.”  Consensus earnings refer to the average forecast based on a collection of broking analysts who publish a forecast for a particular stock.

For example, investment banks and brokers such as Macquarie Group (ASX: MQG) and Wilson HTM (ASX: WIG) employ equity analysts within their stock broking divisions to “cover” different companies. This involves keeping up to date on a company, making an educated estimate of its earnings over the next couple of years and determining a “fair” value for the stock.

Analysts who work for brokers spend a lot of time following the companies they “cover,” so in aggregate the next year consensus number is often a reasonable approximation. Morningstar is one provider that aggregates analyst estimates to provide a consensus number which investors may find to be a useful guide or reference point when conducting valuation.

Many investors choose to use the price-to-earnings (PE) ratio for valuing stocks. While there are limitations to the PE ratio as an accurate valuation measure, it can be a good start provided the investor considers not only whether the stock in question deserves to sell at a premium or discount  PE ratio compared with either its peer group or the wider market but also considers whether the peer/market PE is reasonable. This style of valuation can be called relative valuation.

Currently the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) is trading on a forward PE of about 14.5 times. With that in mind here are three companies that arguably deserve to trade at least in line with the market multiple, yet based on Morningstar’s consensus estimates of earnings per share (EPS) for financial year 2014 are trading at more than a 20% discount.

  • Seven Group (ASX: SVW) Share Price $8.13, EPS 70 cents, value at market multiple $10.15, implies 25% upside.
  • Orica (ASX: ORI) Share Price $20.30, EPS 179.2 cents, value at market multiple $25.98, implies 28% upside. (note September year-end)
  • Bradken (ASX: BKN) Share Price $5.77, EPS 55.2, value at market multiple $8, implies 38.6% upside. 

Foolish takeaway

As noted above, there are dangers with setting a company’s value based on the market multiple, so this should be just the starting point for investors to help uncover potentially undervalued stocks.

The next step for investors is to determine whether adjustments above or below the market multiple are required to take in company-specific factors before arriving at a conservative estimate of fair value.

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Motley Fool contributor Tim McArthur owns shares in Macquarie Group and Wilson HTM.

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