Tesco (LSE: TSCO) shares have suffered in this year’s market sell off.
The UK’s largest supermarket now offers a 5% dividend yield and trades on a modest 10 times earnings. I think we could see the shares bounce back at some point, perhaps when inflation starts to ease.
If I bought Tesco stock today, how much could I realistically expect to earn over the next five years? I’ve been crunching the numbers to find out. Here’s what I think.
Growth potential?
Tesco currently has a 27% share of the UK grocery market. That means it collects £1 out of every £4 spent on groceries in the UK. Second-place Sainsbury’s is a long way behind, with a market share of 14.7%.
I expect Tesco to remain the UK’s largest supermarket. But I don’t think it will be able to gain much more market share. Despite this, I do expect Tesco to be able to increase its profits over time.
Profit growth could come from some of the group’s other businesses, such as wholesale, mobile, and banking. Profit margins on groceries could also rise if the economic outlook improves and shoppers switch back from cheaper own brands to premium products.
A buying opportunity?
The total investment return from a dividend stock has two elements — dividend income and share price gains (or losses).
Tesco’s dividend last year was 10.9p. I suspect growth will be limited over the next few years as the company tries to maintain dividend growth without paying out more than it can afford.
I’ve assumed average dividend growth of 2.5% each year for the next five years. That would mean I’d receive dividends totalling 57.8p per share over this period. That’s equivalent to a 27% return on today’s share price of 214p.
Of course, I’d also hope to see some share price gains over this period too. One common technique used by analysts to forecast share price growth is to assume that the dividend will increase by the same percentage as the dividend each year.
In my model, this would see Tesco’s share price rising by an average of 2.5% per year — an increase of 13% over five years.
Adding my dividend and share price estimates together gives me a forecast total return of 40% over five years. That’s equivalent to a 7% annualised total return, broadly in line with the long-term average from the UK market.
Tesco shares: a buy today?
Of course, all the numbers I’ve discussed above are only a guess. It’s impossible to predict share price movements and I can’t be sure how Tesco’s dividend will change. Even so, I find this kind of model useful when I’m looking for undervalued shares.
In this case, my feeling is that Tesco looks reasonably valued. In my view, the stock might be slightly cheap, but certainly isn’t a screaming bargain.
I think Tesco’s 5% dividend yield should be pretty reliable over the next few years. But I suspect growth will be limited. For a mix of income and growth, I think there are probably better choices elsewhere.
