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Cheap shares: is Persimmon worth the risk?

Photo of a man going through financial problems
Image source: Getty Images

Investors are always keeping their eyes peeled for cheap shares. I certainly am. But what are ‘cheap’ shares? I don’t mean stocks that are simply cheaper than they were a year ago, I’m talking about meaningfully undervalued companies.

One stock that has tanked over the past year is Persimmon (LSE:PSN). The housebuilder is down 42% over 12 months. So is Persimmon cheap for a reason, or undervalued?

What’s behind the fall?

Last year wasn’t a bad one for the housebuilder. House prices had been climbing and volumes were close to pre-pandemic levels. In the first half, the average selling price for a new home built by the company rose by £9,400 year on year, to almost £246,000.

However, the macroeconomic environment was clearly changing, and higher interest rates have dampened demand for property. Building cost inflation is also running around 5%. These factors have contributed to a less-than-optimal environment.

Things got worse for investors in late 2022 when the firm announced that “ordinary dividends will be set at a level that is well covered by post-tax profits”. This meant that the huge 18% yield would be cut. It was unsurprising but not positive news. The 2022 dividend per share will be announced in March.

And, as a shareholder, I was rather frustrated by Persimmon’s wildly inaccurate estimate for its fire safety pledge. In early 2022, Persimmon said that its pledge — the cost of recladding homes deemed unsafe after the Grenfell disaster — would cost £75m. However, a few months ago it raised its estimates to £350m — approximately 40% of pre-tax profits in 2021/2022. I felt rather misled.

Are things improving?

The firm recently said forward sales had fallen by more than a third as customers deferred major purchase decisions. Reasons include the end of the Help to Buy scheme, little sign that interest rates will fall before H2, and the cost-of-living crisis.

From a macroeconomic standpoint, the situation still isn’t positive, despite some analysts suggesting we will now avoid a recession. Inflation data is key to this. With double digit inflation, the Bank of England will have to keep rates high. And very few analysts see rates falling before H2.

The stock has traditionally traded at a premium versus its peers. There are several reasons for this. For one, Persimmon has previously achieved higher gross margin on its land bank, in turn driving improved returns.

However, investors will require further reassurance that it deserves this premium before the share price pushes up. Much of what we learnt about the firm over the past decade appears to have been unwritten. And the fire safety debacle has likely challenged investors’ confidence.

Concerning valuation, Persimmon’s forward price-to-earnings ratio for is 8.43. That’s clearly quite attractive. But I’m a little concerned that might be a bit optimistic.

I’m keeping my power dry on this one. I already own Persimmon stock, but I’m not willing to buy more right now. Uncertainty is a major factor here and I can’t accurately assess whether it’s undervalued or not.

The post Cheap shares: is Persimmon worth the risk? appeared first on The Motley Fool UK.

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James Fox has positions in Persimmon Plc. The Motley Fool UK has no position in any of the shares mentioned. 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.

Motley Fool UK 2023