Is the Tesco (LSE: TSCO) business worth over a fifth more than it was at this time last year? That is what may seem to be implied by the Tesco share price moving up by 22% over the past 12 months.
Then again, it could be that the share was simply undervalued last year and the price has risen to reflect that. Or it may be that it is overvalued now.
What is going on – and could this be a good moment to add some Tesco shares to my shopping basket?
Obvious strengths, but some challenges too
Clearly there is a lot to like about the business.
Demand for groceries is high and tends to be resilient. Even during a tough time economically, people need to eat. Indeed, Tesco’s value-focussed proposition helps make it competitive in this regard. Although, while it may win shoppers from pricier rivals, it does also risk being undercut by cheaper discount supermarkets.
The challenge is that the attractiveness of this industry’s high demand means it is very competitive. It has grown even more so over time, thanks to the likes of Aldi and Lidl relentlessly focusing on price.
That helps explain why the profit margins can be thin. In its most recently reported year, for example, Tesco turned over £69.9bn. But its net profit of £1.6bn equates to a net profit margin of just 2%.
Meanwhile, Tesco’s leading position in the market – by some way – gives it economies of scale. But it also limits the opportunity for growth through acquisitions.
Tesco has reduced its international footprint over the past decade. Taken together, those factors mean I think the growth story for Tesco is limited – and feel its share price ought to reflect that.
Not a bargain
Does it?
I do not think so. The share price growth over the past year reflects investor enthusiasm rather than a dramatically better business performance, as I see it.
But it means that the Tesco share price-to-earnings (P/E) ratio now stands at 20.
To me that looks too high.
Yes, Tesco still has a dividend yield of 3.1%, slightly above the FTSE 100 average. And yes, the P/E ratio is still lower than domestic rivals like J Sainsbury on 24, let alone US giant Walmart, with a P/E ratio of 39.
But 39 strikes me as too high a P/E ratio for a grocer, even one with the sort of ongoing international growth opportunities Walmart has.
Tesco’s P/E ratio of 20 looks racy to me. This is an industry in which growth is likely to be modest, or low. Profit margins are thin and competition is relentless.
Tesco faces risks including inflation and higher staff costs, weak UK consumer demand, and ongoing expansion by rivals. Between this year and next, Aldi plans to open 80 new stores in the UK. Lidl’s current financial year has seen it target 40 new store openings in the UK.
Against that backdrop, I do not find the Tesco share price attractive and will not be investing.
