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The Tesco share price could be undervalued by 50% right now.

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A shopping basket filled with Tesco own-brand goods
Image: Tesco

The Tesco (LSE: TSCO) share price has dropped significantly since the pre-pandemic days. It crashed once in 2020 with the rest of the market and then again earlier this year. Despite this, Tesco remains a very strong business and some analysist believe it could be 50% undervalued.

Does this mean I should add it to my portfolio?

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Fundamentals

Tesco is a multinational grocery and retail chain and is the third-largest retailer in the world by gross revenue. Within the UK it is the largest of the ‘big four’ supermarket chains by market cap, with a 10% lead over the nearest competition.

Tesco’s total market cap is $20.94bn and its shares have a price-to-earnings ratio of 3.17. On top of that the company pays a modest dividend of 3.38% each year. These are all very solid fundamentals. Nothing exciting, like Tesla, but I could do far worse.

Tesco has a couple of strong business moats too. It has strong brand recognition and is considered good quality without being expensive. While economic ups and downs may impact revenue across the market, we all need to buy food every week.

So why are Tesco shares so cheap?

Price drops

Tesco shares fell along with the rest of the market in 2020 and then dropped again in February 2021. The second drop was prompted by the sale of Tesco’s business in Thailand and Malaysia. The resulting cash injection was used to pay a special dividend. This was nice for the shareholders, but by not choosing to re-invest that cash, Tesco essentially shrank its own business by $5bn.

That accounts for the recent drops, but why has the share price stayed so low?

I think that it’s because, while demand for groceries remained relatively stable, profits have decreased. In April 2021, Tesco announced revenue growth of 7% over 2020, but a 20% drop in profits. This could be due to a number of factors, like increased transportation costs or loan repayments. It could even be down to cash strapped customers choosing cheaper items with smaller profit margins.

Should I buy?

The real question is, of course, which of these factors weighs heaviest in my decision? Do I think the share price will go up or stay down?

The truth is that Tesco’s revenues have been falling since 2012. Those previously mentioned drops are nothing compared to the general downward trajectory of the share price. Tesco shares sold for 609p in 2007 and fell all the way to 305p before Covid. They currently trade for 272p each.

Transport costs are only going to go up because of the price of fuel. This is compounded within the UK by the complications brought on by Brexit. 

But I think I will add it to my portfolio. Tesco remains a solid business that pays its shareholders a reasonable dividend. Even with the recent drops, it has high revenue, and yearly profits in the billions. Tesco has shrunk its business outside of the UK but remains an international player.

As Covid restrictions end, the additional costs it incurred will also fall by the wayside, boosting profitability to pre-pandemic levels.

If it is able to increase its profitability in years to come, then the current share price looks like a steal.

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James Reynolds has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco. 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.

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