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Is the Tesco share price one of the FTSE 100 bargains of the year?

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Man shopping in supermarket
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Tesco (LSE: TSCO) shareholders have been waiting a long time for what was once seen as the unassailable leader of the UK’s grocery market to get itself back to health. Now that the shares have put on a bit of a spurt, is it back to business as usual as part of the backbone of the FTSE 100?

Results for 2017-18 released in early April spoke of “another strong year of progress,” with pre-tax profit finally back to an attractive level of £1.3bn after sales rose by 23%. Crucial for me was a gain in operating margins to 3%, with the company still optimistic about reaching its target of 3.5% to 4% by the 2019-20 year. In these days of intense price-cutting competition, that’s not bad at all.

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But to return to its old model of success, I reckon Tesco is going to have to get its dividends back into the 3% to 4% range, and that’s still looking like it could be a few years away. The 3p declared for the year just ended yielded a modest 1.5%, and the sharp rise in the share price response to these results has already pushed the forecast yield for the current year down to just 1.2%.

There’s double-digit annual EPS growth pencilled in for the next few years, but forecasts suggest the dividend won’t be close to the 3% level until 2020 — and any further share price appreciation would act as a drag on that.

Better than the FTSE 100?

I’ve always thought Tesco’s valuation should come in close to the FTSE 100’s overall valuation, though in the past it has done a little better based on its overseas expansion and getting its fingers into a number of non-supermarket businesses. But those days are in the past, so what’s the comparison like now?

The Dividend Dashboard from AJ Bell is now updated for the first quarter of 2018, and once again we hear that FTSE 100 dividends are still on the rise. With around £87.5bn in cash set to be handed out this year, we’re looking at an overall yield for the index of 4.4%. As Dividend Dashboard points out, cover is looking a bit thin at some of the highest payers, but that’s still historically high. And the Footsie is in one of its best periods for some years for income investors.

Thanks to its recovery, Tesco shares are now up by 33% over the past 12 months, against the weak 1% from the index as a whole — but over five years, Tesco is still on an overall loss and lagging the FTSE by some margin. But it’s the future that counts, so what is Tesco’s valuation saying about that?

Although I’m impressed by the latest figures, I’m less impressed by the P/E valuation currently afforded to Tesco shares. After the April price rise, forecasts are suggesting a multiple of over 20, and it would take until 2020 for that to drop to around 15 — closer to the FTSE’s long-term average. I think there’s a lot of Tesco’s recovery potential already factored-into the share price.

I am convinced that Tesco will get back to paying a steady 3% to 4% dividend, but I don’t see it as worth a premium valuation. I can see the stock becoming something of an echo of the overall FTSE 100, and I’d put my money in an index tracker instead.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco. 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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