The forward price-to-earnings (P/E) ratio — share price divided by the consensus of analysts’ forecasts for earnings per share (EPS) — is probably the single most popular valuation measure used by investors.
However, it can pay to look beyond the consensus to the spread between the most bullish and bearish EPS forecasts. The table below shows the effect of different spreads on a company with a consensus P/E of 14 (the long-term FTSE 100 average).
| EPS spread | Bull extreme P/E | Consensus P/E | Bear extreme P/E |
|---|---|---|---|
| Narrow 10% (+ and – 5%) | 13.3 | 14.0 | 14.7 |
| Average 40% (+ and – 20%) | 11.7 | 14.0 | 17.5 |
| Wide 100% (+ and – 50%) | 9.3 | 14.0 | 28.0 |
In the case of the narrow spread, you probably wouldn’t be too unhappy if the bear analyst’s EPS forecast panned out, and you found you’d bought on a P/E of 14.7, rather than the consensus 14. But how about if the bear analyst was on the button in the case of the wide spread? Not so happy, I’d imagine!
Tesco
Today, I’m analysing the UK’s number one supermarket Tesco (LSE: TSCO). The data for the company’s financial year ending February 2015 is summarised in the table below.
| Share price 303p | Forecast EPS | +/- consensus | P/E |
|---|---|---|---|
| Consensus | 27.0p | n/a | 11.2 |
| Bull extreme | 32.0p | +19% | 9.5 |
| Bear extreme | 23.3p | -14% | 13.0 |
As you can see, with the most bullish EPS forecast 19% higher than the consensus, and the most bearish 14% lower, the 33% spread — which is about on a par with rival J Sainsbury — is narrower than 40% spread of the average blue-chip company.
Going back a few years, supermarket spreads tended to be even tighter. That was when the ‘Big Four’ (add Asda and Wm. Morrison Supermarkets to the aforementioned pair) had things easy, edging backwards and forwards against each other, pinching or losing nought-point-something-per-cent of market share here and there. Price wars were always phony wars, and its was all very predictable and cosy.
However, in the face of post-financial-crisis austerity, and the rise of hard discounters Aldi and Lidl, Tesco’s complacency within its UK operations was revealed by a shock profit warning at the start of 2012.
The viability of Tesco’s turnaround plan, the implications for the group’s international operations, whether new chief executive Philip Clarke was up to the task and a whole load of other uncertainties, saw analysts pondering multiple imponderables, and the range of possible earnings scenarios widened dramatically. (The current EPS spread between bull and bear extremes for Morrisons, which has just recently warned on profits, is a massive 143%!)
I’m a little surprised, then, that the spread for Tesco, where a turnaround still hasn’t really happened, is now as narrow as 33%. It suggests that earnings visibility is improving in analysts’ eyes — even if it is in the context of a further year of falling EPS.
This looks promising, though, because even on the most bearish EPS forecast, Tesco is trading on a P/E of 13 — below the FTSE 100 long-term average of 14. Add to this a consensus P/E of 11.2, a bull scenario below the bargain threshold of 10, and tentative expectations of the EPS decline bottoming out next year, and I reckon the risk-reward balance could now be tipped towards reward for long-term investors.
