Invest in what you know. This simple phrase is often regarded as one of the best guidelines when first starting private investing. I have followed this approach frequently, looking for companies that sell goods or services I have purchased and used. This personal experience allows me to gain an understanding of the business model without needing vast amounts of additional research.
Tough few years
For this reason, I looked at Tesco (LSE: TSCO), one of the world’s largest supermarkets. The stock has struggled over the last few years, falling almost 10% in 2020. It stayed flat in 2021, before dropping 23% this year. Consequently, the company is down over 31% from pre-pandemic levels, even after the share rebound in the last month. These considerable declines have resulted in a price-to-earnings (P/E) ratio of 10.2. This is forecast to remain more or less the same next year.
This price instability can be better understood by looking at the performances of the last few years, as these have also been quite irregular. Despite a strong recovery, turnover is still below pre-pandemic levels. However, bottom-line profit has now exceeded pre-2020 figures. This is also reflected in analyst forecasts, which expect turnover to grow by 6.5% next year, considerably above the three-year average. By contrast, earnings per share (EPS) are expected to fall by 4.5%, which could be more encouraging, especially compared to the three-year average growth of 7.4%. This mixed performance makes the unstable share price more understandable over the years.
Underlying fundamentals and dividend
When looking deeper into the current fundamentals of the business, it is once again a mixed bag. Profit margins are relatively low, although this is to be expected within the retail industry. Free cash flow generation is strong, sitting significantly above its three-year average. The efficiency with which earnings are generated on invested capital is reasonable and is also above its average.
The current dividend is appealing too, with a yield of 4.9%, and this dividend has been paid consistently for the last five years. However, the yield has only grown over the previous year and is forecast to decline in 2023 to 4.7%. The company has dividend cover of 2, so it can comfortably cover the yield with EPS, although this expected reduction is still not a particularly good sign.
Challenging future
From a pure valuation perspective, Tesco shares look appealing due to the low P/E ratio and improving earnings. However, the broader macroeconomic situation is looking quite bleak, which could cause more issues for the company. Elevated inflation levels and the cost of living crisis are likely to hamper consumer demand, and with its already slim margins, this could begin to take its toll. Furthermore, debt levels are very high, at almost 93% of market capitalisation, so further headwinds will add more strain on these already elevated debt levels.
Therefore I would not be keen to add Tesco to my portfolio at this stage. The shares are reasonably valued and have fallen considerably over the last year. However, a combination of mixed fundamentals and adverse macroeconomic risk mean I would look elsewhere for portfolio additions right now.
