How to be an investor, not a gambler.
Last month I wrote The Bargain Hunter's Checklist, a ten-point list of things to review before you buy a share. That article was intended as a pre-purchase checklist for investors of all levels: a reminder to ensure the most important bases had been covered before getting swept up in the hunt for bargains as the market plunged.
But reader bobthebeginner suggested it would be useful for new investors to see the checklist applied to a particular share, such as Tesco (LSE: TSCO). It seemed a good platform to demonstrate some basic investment principles, so here is exactly that. Of course, company evaluation can be a time-consuming and complex task, and whole books have been written about the subject, but if you think about just these ten points on the checklist before you buy, then you are certainly investing, not gambling.
Most of the data I've used is taken from the Tesco pages on the Motley Fool website, reached by entering Tesco's ticker TSCO in the search box at the top of the page. I also used Digitallook, which provides the data to the Motley Fool. Statistics are based on a share price of 406p.
1. Check the P/E and share price history
The P/E ratio is the most widely quoted statistic, but as there are so many different ways to calculate it, the ratio is also one of the most problematic. The P/E is most useful when used in comparison -- across time, or between companies. So it is essential to take the P/Es you're comparing from the same source.
The Digitallook website has these P/Es for Tesco and its two listed peers:
| ||Latest PE||Forecast|
|Wm Morrison (LSE: MRW)||13.2||12.0|
|J Sainsbury (LSE: SBRY)||11.3||11.0|
This shows us that the three supermarkets trade roughly at the same level, with Morrison's slightly higher P/E suggesting the market expects faster growth. Tesco's P/E is in line with its historical year-end value for the past five years, so on that basis at least the share is currently neither especially expensive nor cheap.
The Charts tab on the Motley Fool site allows us to look at Tesco's share-price performance over various time periods, and compare it with the FTSE 100. There's no dramatic story here: Tesco has broadly kept pace with, and often outperformed, the market. But the share price did drop in the market sell-off during August, so it could have looked cheap if we had done this exercise then.
2. Check dividend cover and track record
The Fundamentals tab on the Motley Fool Tesco page shows a nicely rising dividend per share over the past five years, which is encouraging. During the last three years, the dividend yield has hovered between 3.0% to 3.5%, close to its current 3.6%. By clicking on Tesco Final and Interim Results and looking down at the ratios section, we can see dividend growth has been around 10% per annum during this period.
Dividend Cover, which is calculated by dividing after-tax earnings by the dividend, has been around 2.5 times. That's generally a healthy cushion, and means Tesco would have to suffer a very serious hit to its business before the dividend would come under threat. The reliable and rising dividend stream should support the share price here, so this is all good news.
3. Are revenues and operating profit rising?
Still looking at the same Motley Fool page, we can see that Revenues and Operating Profit have risen over each of the past four financial years to February 2011, and also in each half year to August 2011. That's a pretty strong track record.
It is also encouraging that the Operating Margin (operating profits as a percentage of revenues, displayed in the ratios section) has remained steady at around 6% in each of the past five years.
4. Does the company generate cash?
We are still on the same Motley Fool page. Within the cash flow statement, we can see that Net Cash Flow from Operating Activities is consistently equal to or larger than Operating Profit, telling us that Tesco's business generates a lot of cash. This is an important check, as companies can report accounting profits but not collect that much in the way of cash. Companies that don't generate cash must eventually borrow more, raise equity, sell assets or go bust.
Net Cash Flow from Investing Activities tells us that a good chunk of that cash is invested in new assets or acquisitions. Unfortunately, the next line on the cash flow statement, Net Cash Flow from Financing Activities, is less helpful as it mixes dividends with raising or repaying borrowing.
5. Check debt
So we have to look at debt levels. Tesco's net gearing is 56% and has ranged from 44% to 96% during the past five years. For a company generating healthy profits, net gearing under 100% shouldn't raise any concerns.
To confirm this, interest cover is (approximately) calculated as Operating Profit divided by Net Interest. It's 11.4 times. A low, single-digit figure could be worrying, but Tesco's cover looks healthy and the firm should easily keep its bankers at bay.
In the next article, I cover the final five points on the checklist.
More from Tony Reading:
> Both Tony and the Motley Fool own shares in Tesco.