Zip Co Ltd (ASX: ZIP) shares are among the biggest movers on Thursday, climbing to around $2.12 as the Australian share market surges.
It's an impressive recovery for the buy now, pay later provider, which has experienced considerable volatility recently.
But despite today's rally, I still think Zip shares are trading at a remarkably cheap valuation.
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Why are Zip shares rising?
I think the broader market rally is worth considering because the developments driving it could also benefit Zip's business.
Investors have welcomed the outcome of the US midterm elections, with Democrats gaining control of Congress and potentially placing greater constraints on government policy.
Meanwhile, oil prices have fallen sharply amid hopes of an easing of the conflict in the Middle East.
I think that could be good news for Zip. Lower oil prices could eventually translate into cheaper petrol, helping consumers keep more money in their pockets.
And if falling energy costs help ease inflation, it could also reduce pressure on central banks to keep interest rates elevated.
Of course, lower interest rates are far from guaranteed, especially given the inflationary pressures that have persisted this year. But I believe an improvement in household finances could create a more favourable environment for Zip.
Consumers with more disposable income may be better placed to spend, while also keeping up with their repayments.
That could support transaction growth and help the company manage credit losses, which have been an area of concern recently.
Why I think Zip is still cheap
While today's market developments are encouraging, my enthusiasm for Zip shares is based primarily on their valuation.
Even after climbing to $2.12, I think investors are paying a surprisingly modest price for the company's earnings prospects.
According to CommSec consensus forecasts, Zip is expected to generate earnings per share of 14.7 cents in FY27, rising to 16 cents in FY28 and 20.9 cents in FY29.
This means between FY27 and FY29 analysts expect Zip's earnings to grow by approximately 19% annually.
Despite this, at today's share price, Zip trades on a forward price-to-earnings (PE) ratio of approximately 14.4 times FY27 earnings. That falls to around 13 times for FY28 and just 10 times for FY29. I think those multiples are difficult to ignore.
Of course, Zip has to deliver on these estimates, but I believe it can.
Zip's latest quarterly update showed that management remains confident in its outlook, maintaining its FY27 guidance for $340 million in group cash earnings before tax, depreciation and amortisation.
That provides some encouragement following the company's recent US fraud incident, which disrupted operations and raised questions about its risk controls.
However, there are still reasons to be cautious. Credit losses increased during the first quarter, and Zip will need to demonstrate that it can control those losses while continuing to expand.
A prolonged period of economic weakness could also put pressure on consumer spending and repayments. But I believe the potential earnings growth more than compensates investors for these uncertainties at the current valuation.
Foolish takeaway
A double-digit share price gain is certainly worth celebrating, but I think Zip's longer-term prospects are much more exciting.
At around $2.12, the shares still look inexpensive relative to the earnings growth analysts are expecting.
And if the economic environment becomes more favourable for consumers, I believe Zip could have an opportunity to deliver even stronger results.
I'd be happy to buy at current levels and give the company several years to demonstrate what it can achieve.
