Tesco’s (LSE: TSCO) share price now sits around an elevated level not seen since the end of 2007. That might suggest that the easy money has already been made, with little value left for new investors.
But this is not true, in my view, because an asset’s price and its value are not the same thing at all.
The FTSE 100 retailer’s scale, data advantage and operational discipline continue to strengthen its earnings profile beneath the surface. And this is likely to drive further gains from here.
So, how high could it go?
Key earnings growth drivers
Earnings growth is the engine that powers rises in any firm’s share price over the long run. A risk for Tesco is a further surge in the cost of living that may cause customers to reduce their spending. However, consensus analysts’ forecasts are that the supermarket giant will see its earnings rise by 9% a year over the medium term.
This view looks well-founded to me in Tesco’s most recent results — fiscal year 2024/25. Adjusted operating profit increased 10.6% year on year to £3.13bn, reflecting solid trading, efficiency gains and continued progress in the Save to Invest programme. Adjusted earnings per share rose 17% to 27.38p, helped by higher profit and ongoing buybacks.
Group sales increased 3.5% to £63.6bn, supported by volume growth across all regions. However, the UK remained a standout performer. Market share went up 0.67% to 28.3%, underlining the strength of its value and loyalty proposition.
Free cash flow came in at £1.75bn, remaining comfortably within the group’s multi-year target range. Net debt improved 2.4% to £9.45bn, supporting a 13.2% increase in the dividend. Overall, the results highlight a business with resilient demand, disciplined cost control and a steadily strengthening earnings base.
What’s the stock’s ‘fair value’?
A share’s price is simply whatever the market will pay for it at any given time. But its ‘fair value’ reflects the true worth of the underlying business.
The gap between these two things is critical for long-term investors making big, consistent profits over time. The reason is that all assets — stocks included — tend to trade to their fair value over the long run.
The best way to ascertain a share’s fair value, in my experience as a former senior investment bank trader, is discounted cash flow (DCF) analysis.
It estimates a company’s fair value by projecting its future cash flows and then ‘discounting’ them back to today. This also reflects consensus analysts’ forecasts for a firm’s earnings growth over time.
Some analysts’ DCF modelling is more bearish than mine, depending on the inputs used. However, based on my DCF assumptions — including an 8.1% discount rate — Tesco is 26% undervalued at its current £4.75 price.
Therefore, its fair value is £6.42.
My investment view
I already have shares in the retail sector — in Marks and Spencer — so another would unbalance the risk-reward profile of my portfolio.
However, for investors without this problem, I think Tesco merits serious attention. It remains a powerhouse market leader in its sector in the UK, with strong earnings growth potential.
I have little doubt that this will drive its share price towards its fair value over time.
