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Why I think the Tesco share price is deeply undervalued

Image: Tesco

I think the Tesco (LSE: TSCO) share price is one of the most undervalued in the FTSE 100. Today, I’m going to explain why I hold this opinion. 

Deeply undervalued

Tesco isn’t the most exciting business on the market. However, the company does provide an essential service to consumers around the UK through its supermarkets, wholesale business, and local stores.

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Further, customers are incentivised to shop in Tesco stores through its Clubcard scheme. In recent years, the company has been boosting its Clubcard offer by combining financial services, mobile phones, and, of course, food shopping. The corporation increasingly provides discounts in store for these card holders as a way of offsetting cheap prices offered by rivals. 

By encouraging consumers to sign up for the Clubcard scheme, Tesco has also built a vast trove of its customers’ data. This information has given the group an edge over competitors. By using the data, it can provide tailored discounts to customers and streamline its inventory process. 

Put simply, Tesco has a substantial competitive advantage both in the size of the operation and the data available to the group, which it can use to make better decisions. 

But despite these advantages, the stock is only trading at a modest premium to its sector. The Tesco share price is selling at a price-to-earnings (P/E) ratio of 12.7, compared to 12 for Sainsbury’s and 12.4 for Morrisons. I think the firm deserves to trade at a significant premium to the sector, considering its advantages. 

What’s more, at the time of writing, the stock offers a dividend yield of around 4%. That’s above the market average and looks highly attractive in the current interest rate environment. 

The final reason why I think the Tesco share price is undervalued is its cash generation. The firm is aiming to produce a free cash flow of £1.2bn every year. This implies the stock is trading at a free cash flow yield of 6.8%.

By comparison, fellow FTSE 100 giant Unilever is trading at a free cash flow yield of 5%. To put it another way, Tesco is around 36% cheaper on a cash flow basis.  

Tesco share price risks

While I believe the stock is undervalued, I can see why some investors might give the business a wide berth. Key risks to its growth include rising costs, which could eat away at profit margins. The retail sector is also incredibly competitive. Tesco has the advantage today, but it may not last long.

These risks could hold back growth and damage those all-important profit margins, which may hurt the company’s dividend prospects. 

Still, despite these risks and challenges, I think the Tesco share price is deeply undervalued. As such, I’d buy the retail champion for my portfolio today as a value and income investment. 

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Rupert Hargreaves owns shares in Unilever. The Motley Fool UK has recommended Morrisons, Tesco, and Unilever. 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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