At £28, this FTSE 250 gem still looks 70% undervalued to me

At £28, this FTSE 250 gem still looks 70% undervalued to me

FTSE 250 fast-food retailer Greggs (LSE: GRG) has become something of a British institution. Its products appeal across all demographics (Steak Bake for me), and last year it replaced McDonald’s as the UK’s top breakfast takeaway provider.

However, its share price does not reflect the firm’s stunning success over recent years, in my view – far from it. I think it should be around 70% higher than where it trades right now.

Huge undervaluation?

A key pointer as to whether a stock is undervalued is the price-to-earnings ratio (P/E). On this measure, Greggs currently trades at 20.2.

The average P/E of its key competitors is 58, so it looks very undervalued on this basis.

I ran a discounted cash flow analysis to ascertain precisely how undervalued it is in cash terms. This used several other analysts’ figures as well as my own.

The results show Greggs’ shares to be about 72% undervalued at their present price of £28.25. This means that a fair value for the stock right now would be around £100.89.

That is a hug difference, although there is no guarantee that the shares will reach that price. But it underlines to me how much of a bargain they look.

Improving dividend prospects

After turning 50, I have avoided growth-only stocks, focusing instead on shares that give a 7%+ yield. Why this figure? Because I can get a risk-free rate of 4%+ from the UK 10-year bond and shares are much riskier.

That said, Greggs is not just an out-and-out growth stock, in my view, as it also pays a dividend. Last year, this was 102p a share, including a 40p special payment. On the present price of £28.25, this gives a yield of 3.6%.

This is in line with the current average FTSE 100 payout, and higher than the FTSE 250’s 3.3%.

However, I think there is every chance it will increase in the coming years, driven by its strong growth.

Growth prospects

Dividends are powered over the long term by earnings growth.

Over the past five years, Greggs’ earnings have increased by an average of 23.4% a year. Its revenues grew at an average rate of 12.5% a year over the period. And its average annual return on equity during that time was 26.8%.

As they say, of course, it is not where you came from but where you are going that counts. And there are risks in the shares, as in all stocks.

The main one is that competitors succeed in eroding its market share through new products or sustained lower pricing. Another is that a resurgence of the cost-of-living crisis prompts customers to cut back on food-to-go.

However, consensus analysts’ estimates are that Greggs’ earnings will grow 5.6% each year to the end of 2027. Revenues are expected to rise by 8.2% a year to that point. And return on equity is forecast to be 26% by that time.

For me, the investment case is compelling, and I will be buying Greggs’ shares at the earliest opportunity. Not to mention, more Steak Bakes, I imagine.

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Simon Watkins has no position in any of the shares mentioned. The Motley Fool UK has recommended Greggs Plc. 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.