Is the Tesco share price too cheap to ignore?

The Tesco share price has been on a great run over the last year. Muhammad Cheema takes a look at whether investors should consider its shares.

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Image source: Tesco plc

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The Tesco (LSE:TSCO) share price has climbed over 20% in the last year.

Considering the FTSE 100 has increased by just over 1% in the same period, this has been a strong run.

To some, it may seem that the opportunity to invest in Tesco shares has been missed.

However, its shares are currently trading at a forward price-to-earnings (P/E) ratio of just 12. This isn’t a dirt-cheap valuation. But, considering its impressive half-year results released last month, I’ll discuss below if it’s still cheap enough to invest in.

High debt

One thing that concerns me about Tesco is its high level of debt.

Its half-year results showed that its net debt is £9.9bn.

If we assume that free cash flow in the second half of the year is the same as the first half, then we should expect a free cash flow of £2.7bn for the year. Therefore, Tesco shares are trading with a free cash flow to debt ratio of 0.2767.

This means that it has the ability to pay just shy of 28% of its debt every year, assuming it spends all its free cash flow to do so.

This is too low in my eyes.

Moreover, the assumption that its free cash flow in the second half of the year is the same as the first half is generous. Last year, free cash flow in the first half of the year was 60% of all free cash flow generated.

However, there is one positive point. Tesco has seen its debt fall from £10.5bn since the end of last year.

Solid growth

While the huge level of debt concerns me, Tesco has done very well in other aspects of its results.

Group revenue increased by 8.9%, from £28.2bn last year to £30.7bn this year.

Earnings per share (EPS) rose by 16.8%, from 10.5p to 12.26p.

Free cash flow also went up by 6.6%, from £1.3bn to £1.4bn.

These results are pretty good in their own right, but what makes it stand out to me is that this is during a period of high inflation.

We are currently in a cost-of-living crisis, where consumers are facing pressure to reduce their expenditures.

You’d therefore expect them to turn to low-cost alternatives, such as Aldi and Lidl.

However, Tesco has not only been able to maintain its revenue and profit but grow it significantly.

Furthermore, it currently has a dividend yield of 4.1%. As an income investor, this certainly caught my eye.

Now what

Ultimately, Tesco is growing very strongly at a reasonable valuation.

I would hesitate to say it’s too cheap because the level of debt is just too high.

But I can still see its shares generate investors decent returns if it continues to perform as it has been recently.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Muhammad Cheema has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco Plc. 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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