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Here’s why the Tesco share price could be heading for a reversal

There’s no doubt that Tesco (LSE: TSCO) shares have started rewarding patient investors in recent months. Thanks to a surge triggered by upbeat full-year results in April, the Tesco share price has put on an impressive 23% since the start of 2018 alone, taking it up 42% over the past 12 months. And that’s while the FTSE 100 has been pretty much pancake flat.

The reason is not hard to see. The company’s fundamental restructuring plan under chief executive Dave Lewis is looking increasingly like an impressive success, and he really wasn’t afraid to take the up-front pain in order to fix the company from top to bottom.

The year ended February 2018 was the second year of hefty earnings growth, with EPS up 57% after a rise of 65% the previous year. Admittedly, though, that was from very low levels after the firm’s big slump, and still only around a third of the EPS figure recorded for 2014.

Solid foundations

My Motley Fool colleague Roland Head recently said that “the group’s financial foundations are much stronger now than they were five years ago” and I agree. Tesco is in much better shape now as a company, on both the profitability and liquidity fronts.

But here’s the problem for me, in one word — valuation.

Tesco’s structural reform seems to be getting close to completion, having set the stage for a return to steady annual earnings growth. And I can’t help seeing the progress of that reform as revealed by quarterly updates and other short-term news flow as having been behind this year’s serious share price appreciation. Investors are notoriously fickle and short-term thinkers, especially the institutions that are focused on only the next set of figures they can publish. Being able to say “yes, Tesco earnings are up 57% and we have them in our fund” can be good for attracting new investment customers.

Use-by date

But as news flow can have a big bullish effect on a share price in the short term, so can a lack of news put gentle downward pressure on shares over the long term. As fellow Fool writer Kevin Godbold puts it, “the turnaround process looks as if it is nearly complete, which makes me believe the short-term turnaround trade in Tesco stock is probably close to its use-by date.

Forecasts suggest the rapid jumps in EPS over the past two years will slow, as they inevitably must, though we still see gains of around 20% per year for the next two years currently being suggested. That’s still impressive, though obviously still above a sustainable long-term rate of growth once the early recovery in profits settles back.

That puts the 257p shares on a forward P/E of a bit over 15 as far out as February 2020. Is that an attractive price? I think it’s probably a fair long-term valuation for Tesco, especially if the company does manage to get its dividend yields up to the forecast 3% by then. But it does suggest to me that the next few years of expected progress are already factored-in to the current share price, and I see the 2018 bull run as over.

Right now, I think there are considerably better opportunities out there than a share price that I expect to give up some of its recent gains over the medium term.

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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.