Tesco’s (LSE: TSCO) share price is trading around a level not seen since October 2013.
Some investors might think the shares cannot go much higher after such a rise. Others may believe that with such momentum the stock must make further gains.
In my experience as a former investment bank trader and now as a private investor, neither view is helpful in share investing. But it might be that the higher share price still does not reflect the real worth of the firm.
Are the shares undervalued right now?
To ascertain how cheap it is in cash terms, I ran a discounted cash flow analysis using other analysts’ figures and my own.
This shows the stock is 41% undervalued at its current price of £3.73, despite its steady rise over the past 11 years. Therefore, a ‘fair value’ for the shares is £6.32.
They may go much lower or maybe higher than that, given the unpredictability of the market. But it underlines to me how undervalued the stock still looks to me.
Does the business outlook support this view?
Recent analysis by investment bank Morgan Stanley suggests Tesco faces a £250m-a-year increase in its National Insurance contributions (NICs). This follows the October Budget’s hike in employer contributions by 1.2%.
I think much of this will be passed on by Tesco in higher prices to consumers. But this may lower its earnings as customers reduce spending and it remains a key risk for the firm. As many businesses have warned of similar increases in costs, a rise in the cost of living may be the result. This would prolong the risk to Tesco’s earnings.
It might be thought that the NIC increase could be more than compensated for by a huge leap in Black Friday weekend business. According to industry data, Tesco added £1bn in value over the most recent such period. However, whether this will be repeated next year – especially if the cost of living rises – remains to be seen.
That said, analysts currently estimate that Tesco’s earnings will grow by 1.5% a year to 2027.
What about recent results?
Tesco saw a 4% year-on-year increase in group sales for the first half of fiscal year 2024/25, to £31.46bn. Adjusted operating profit jumped 15.8% to £1.65bn.
These rises were attributed by the firm to its strategic focus on price, quality and innovation. And in this context, H1 saw the launch or improvement of over 860 products and lower prices on thousands of product lines.
For the full fiscal year, Tesco forecasts around £2.9bn of retail adjusted operating profit against £2.8bn last year.
Will I buy the shares?
I am toward the later stage of my investment cycle, focusing on stocks that pay high yields. Tesco’s annual return is presently 3.2%, so it is not for me on this basis.
However, had I been at an earlier stage of the cycle, the stock would be on my watchlist to buy. I think it will be one of the two or three big winners in the UK supermarket sector over time, which should power its share price and dividend higher.
However, I would wait to see the effects of direct and indirect taxes on retail businesses in the coming year or so.
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Simon Watkins has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco Plc. 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.
