When a company is growing profits and its share price, it is usually fairly easy to value the business – the faster the company is growing, generally the higher the P/E ratio will be.
But what if the company’s profits and share price are falling? When is the firm cheap, and when is it expensive? That’s a much more difficult question to answer.
An incredible fall in profitability
Take Tesco (LSE: TSCO). This used to be one of the world’s leading retail chains, churning out higher profits each year. In 2007 the company’s share price peaked at 488p, but then fell steadily, reaching 165p late last year. That’s quite a fall. Since then, the share price has risen to 242p.
So are the shares now cheap or expensive? Is it time to load up on Tesco stock, or will the business’s valuation fall lower? Is the firm a contrarian play or a value trap?
Well, let’s look at Tesco’s recent and predicted earnings per share:
2012: 39.23p
2013: 19.06p
2014: 23.72p
2015: 9.86p
2016: 8.58p
Considering that this has been one of the stalwart blue chips of the FTSE 100, popular with small investors, fund managers and pension funds, that’s an incredible fall in profitability. Yet, interestingly, the turnover of the firm has scarcely fallen at all from 2012 to 2016.
To turn around the supermarkets, you need to turn around their margins
This means that the profit margins of supermarkets such as Tesco, Sainsbury’s and Morrisons are tumbling. So, whether you think Tesco is cheap or expensive depends upon whether you think it can rapidly recover its margins, or whether the supermarkets have now reached a new era of greater competition and lower profits.
My feeling is that Tesco’s profitability, and its share price, can be turned round. After all, surely this was the reason why the firm’s executives hired Dave Lewis, who helped turn round Unilever in impressive style.
But the lessons we can learn from the chief executive’s experience with Unilever is that these corporate transformations take time. I think it will take several years to see Tesco’s margins, profitability and share price recover.
So my opinion is that Tesco will eventually be a contrarian play, but investors will need to be patient. My view is over the rest of this decade, rather than just over the next few months. The share price will fluctuate from week to week and month to month, but you need to take a long-term view with this company.
That’s why I would rather wait a few years to see how things pan out. I think Tesco is a contrarian buy, but I won’t be investing just yet.
