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This is what I’d do about the Morrisons share price right now

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I’m going to come right out and say it. I think the Wm Morrison Supermarkets (LSE: MRW) share price is too high.

The recent 240p price throws up a forward-looking price-to-earnings (P/E) ratio for the trading year to February 2020 of about 17, and the predicted dividend yield is 3.9%. That’s a rich valuation for a high-turnover, low-margin enterprise, in my view.

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A challenged sector

If you look at the traditional quality indicators, the numbers scream ‘poor quality’. The return-on-capital figure is running at just under six and the operating margin barely moves the dial with a paltry two or so. It wasn’t long ago that many investors were attracted to the big supermarket chains for their consistent incoming cash flow. But the five-year record for Morrisons shows a trend in cash flow that’s broadly down.

It wouldn’t take much of a change in the big figures of revenue and costs to produce a negative in the small figure for profits, I reckon. And the supermarket sector is competitive. Morrisons doesn’t have anything much of a unique offering – all supermarkets can more or less do what it does. So there isn’t anything of a protective economic moat. The enterprise is at the opposite end of the scale compared to those trading in a profitable, well-protected niche in the market.

But it gets worse. As well as being a difficult and competitive sector, the supermarket industry is up against disruptive and aggressive new competition from hard-discounting and fast-expanding rivals such as the German-owned chains Aldi and Lidl. I don’t think the medium- to long-term outlook is attractive for the old guard in the UK, such as Morrisons.

That’s why I’d rather see the valuation lower, perhaps a P/E rating below 15 and a dividend yield above 5%. Even then I’d be reluctant to buy the shares, although you could make more of an argument for collecting the dividend.

Downside potential

Meanwhile, it’s hard to understand why investors have pushed the valuation so high. City analysts are predicting high single-digit advances in earnings this year and next, but even allowing for that, I think the valuation will be too rich. So it must be excitement in the air about the firm’s potential to keep on recovering. But I’m more focused on the company’s potential to relapse. After all, earnings plunged just over three years ago and the directors cut the dividend to around a third of its previous size.

I think the current valuation takes too much on trust and I’d rather see the progress on profits in the bag rather than being paid for upfront by investors like this. If I wanted to bet on a turnaround in a recovering business I’d go for one with better economics and better showings on the quality indicators in the first place. I think there’s a lot of risks involved in holding Wm Morrison shares now, so I’m avoiding them.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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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