Why Are People Buying Tesco PLC At These Ridiculous Prices?

Beleaguered grocery play Tesco (LSE: TSCO) has enjoyed a terrific run so far in 2015, the company benefiting from the same giddy investor appetite that has powered the FTSE 100 to all-high peaks around 7,000 points. And while the 6% gain enjoyed by London’s blue-chip index is no doubt impressive, this is easily eclipsed by Tesco’s 30% rise during the period.

Market opinion towards Tesco has also been helped by the release of chief executive Dave Lewis’ much-awaited turnaround strategy in late January. Still, I believe that share prices have become too frothy at present, and that a sharp correction could be around the corner given the difficulties Tesco still has to hurdle.

Poor earnings prospects at premium prices

Indeed, I reckon that Britain’s number one grocery chain offers very little value to either growth or income seekers. Against a backcloth of worsening competitive pressures, Tesco is anticipated to punch a third consecutive annual earnings loss in the year concluding February 2014, and a 67% decline is currently pencilled in.

City analysts expect the business to get back in business from this year, however, and a 6% uptick for fiscal 2016 is tipped to accelerate to 28% in 2017. Despite this predicted turnaround, Tesco still deals on elevated P/E multiples of 22.6 times and 17.3 times prospective earnings for these years — I would consider a reading around the value benchmark of 10 times or below to be a fairer reflection of the risks facing the supermarket.

It is true that newsflow coming out of the Cheshunt firm in recent weeks has been more encouraging. The firm has outlined a raft of cost-cutting measures, such as the mass closure of underperforming outlets and the shuttering of its Cheshunt HQ, while schemes to resuscitate the top line — including slashing the number of stocked items by a third to make it easier for shoppers to compare prices — should also boost sales.

Still, Tesco has a hell of a fight on its hands to stem the charge of both the premium chains and discounters, particularly as both are shoving vast sums into ambitious expansion plans. Tesco on the other hand is having to slash expenditure as shopper desertions have hammered the balance sheet.

Dividends poised to disappoint

Indeed, these capital stresses forced Tesco to cut the interim dividend by three-quarters back in the summer, and the City expects a full-year payout of just 1.2p per share for fiscal 2015, down from 14.76p the previous year. And a further reduction is anticipated this year, to 1.1p, resulting in a miserly yield of just 0.4%.

The dividend is expected to recover in line with earnings in fiscal 2017, to 4p, although this projection still produces an underwhelming 1.6% yield. And considering the fragility of Tesco’s earnings outlook, I believe that even the figures for this year and next could be stretching the imagination.

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Royston Wild has no position in any shares mentioned. The Motley Fool UK owns shares of Tesco. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.