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, itsFY2016 results published in November werent received well by the market and the tobacco giants share price endured a significant fall to around3,400p.
At the time, I suggested that the fall was overdone. Itsrelative 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 companys 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 couldnt 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 theres still plenty more to come from Imperial Brands and by my calculations, the stock could return over 30% in the next 18 months. Heres why.
Relative valuation is an effective valuation technique that involves the use of other similar, comparable assets in assessingan asset.
In the case of Imperial Brands, I think its worth comparing the stocks 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, its clear to see that Imperials 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 Imperials.
That to me seems unjustified, especially given that itpays the highest dividend of the lot. So whats a fair P/E ratio for the firm? Thats the critical question.
Clearly, the market has some concerns over itsgrowth profile, despite managements 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 ofBritish American Tobacco, and I see no reason why itcouldnt 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 approximately220p of dividends in that period and were looking at a total return of 32% not bad for a FTSE 100 giant.
Of course, theres 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.
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.