Six months ago Imperial Brands(LSE: IMB) was a FTSE favourite, with the Brexit result sending sterling lower and demand for defensive stocks soaring. However, its FY2016 results published in November weren't received well by the market and the tobacco giant's share price endured a significant fall to around 3,400p.
At the time, I suggested that the fall was overdone. Its relative strength indicator (RSI), a key momentum indicator that compares the magnitude of recent gains and losses to identify if an asset is overbought or oversold, suggested that the stock was heavily oversold. And with the company's forward looking P/E ratio falling to just 12.5 while its yield spiked to 4.5%, Imperial stood out as a real bargain in my eyes.
As an investor who likes to buy quality companies at attractive valuations, I couldn't help but have a nibble at Imperial, taking a position around the 3,500p mark. And so far, the investment has panned out well, rising 7% in just a few months, with dividends on the way. However, I think there's still plenty more to come from Imperial Brands and by my calculations, the stock could return over 30% in the next 18 months. Here's why.
Relative valuation is an effective valuation technique that involves the use of other similar, comparable assets in assessing an asset.
In the case of Imperial Brands, I think it's worth comparing the stock's 2017 P/E ratio to those of its 'big tobacco' competitors in the UK and the US. Take a look at the table below.
* Reynolds American P/E calculated using pre-takeover share price.
Looking at the table, it's clear to see that Imperial's price multiple is way below that of its peers. Indeed, the average P/E ratio of the other four big tobacco companies is a lofty 20.1 times 2017 earnings, 48% higher than Imperial's.
That to me seems unjustified, especially given that it pays the highest dividend of the lot. So what's a fair P/E ratio for the firm? That's the critical question.
Clearly, the market has some concerns over its growth profile, despite management's pledge to reinvest £300m for "selected quality growth opportunities."
However, with plans to penetrate the huge Chinese market through a joint venture with China National Tobacco, I believe the growth concerns are overdone. Add in the fact that Imperial has a forward dividend yield of 4.4%, which is 1% higher than that of British American Tobacco, and I see no reason why it couldn't trade on a similar P/E to its UK rival within 18 months.
British American trades on a P/E of 17.2, meaning that if Imperial was to catch up to its peer over the next 18 months, a share price gain of 26% could be on the cards. Add in approximately 220p of dividends in that period and we're looking at a total return of 32% - not bad for a FTSE 100 giant.
Of course, there's absolutely no guarantee that Imperial Brands will perform like this and if global markets fall, all bets are off. But if markets remain stable over the next 18 months, I believe it has the potential to play catch-up to its peers and as a result, could reward shareholders handsomely.
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Edward Sheldon owns shares in Imperial Brands. The Motley Fool UK has recommended Imperial Brands. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.