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Tesco’s (LSE: TSCO) share price has risen 34% from its 10 April one-year traded low of £3.10. This leaves it just 4% off its 24 July 12-month high of £4.31. And the last time that level was seen was January 2011.
This does not necessarily mean no value remains in the stock. After all, price and value are not the same thing. Price is whatever the market will pay for a stock at any given time. Value is the true worth of the share, derived from the underlying business’s fundamentals.
Understanding this difference and being able to quantify it is crucial for generating significant profits over time, in my experience.
The price-valuation balance
I believe a good starting point in assessing a stock’s price is to contrast its key valuations with its competitors.
Tesco’s price-to-sales ratio of 0.4 is the second-highest in its competitor group, which averages 0.3. These firms are Carrefour at 0.1, J Sainsbury at 0.2, Koninklijke Ahold Delhaize at 0.3, and Marks and Spencer at 0.5.
So, Tesco is overvalued on this measure.
It is also overvalued on the price-to-book ratio (and second-highest among its peers) – at 2.3 against a 1.6 average.
However, on a price-to-earnings ratio of 16.8, it is undervalued compared to the 21.1 average of its competitors.
The second part of my assessment pinpoints where any firm’s shares should trade, based on underlying business cash flow forecasts.
This is done through a discounted cash flow analysis, and shows Tesco is 12% undervalued at its current £4.14 price.
Therefore, its fair value is £4.70.
The risk-reward balance
Even with no other factors considered, a 12% undervaluation is nowhere near enough for me to consider buying the stock. Such a percentage variation could be negated up or down through market volatility at any time.
And Tesco offers just below the Footside average in additional shareholder compensation in the form of dividends.
In fiscal year 2024/25, it paid a dividend of 13.7p, giving a current yield of just 3.3%.
By comparison, the average FTSE 100 dividend yield is presently 3.5%. The ‘risk-free rate’ (the 10-year UK government bond yield) is 4.5%. And I own several shares that yield well over 7% and are 50%+ underpriced to their fair value.
Moreover, some considerable risks appear relative to the stock. UK inflation continues to rise, adding to the cost-of-living pressures. This could cause customers to further cut back on their shopping.
In this environment, competitive pressure continues to intensify, which could squeeze Tesco’s margins further. And the effects of last October’s Budget increase of 1.2% in employers’ National Insurance will continue to be felt.
My investment view
I know perfectly well that Tesco is a fundamentally solid business. But that does not mean I will pay any price to own the shares. This applies to any firm’s stock.
It is true that analysts forecast its earnings will grow 6.2% a year to end-fiscal year-2028. And it is true that growth here powers a firm’s share price and dividends long term.
But its under-pricing to fair value is marginal and its low dividend yield offers no additional incentive for me to buy it.
I would much rather add to my holdings of more undervalued and higher-dividend-yielding shares.
