The Tesco (LSE: TSCO) share price is increasingly close to hitting a new 10-year high. In late July 2014, it was trading at around 330p, just a few percentage points from the current 318p price.
But with the price now so high, what might the future hold?
Evaluating value
There are several ways to evaluate whether a stock is currently trading at good value. In other words, the price appears to be lower than it should be and has growth potential.
However, the metrics typically use past, or trailing, data that isn’t necessarily indicative of future performance. As such, they should be used in conjunction with other information about the industry, management, and board decisions to get the full picture.
Price vs earnings growth
One good metric that I think is under-used is the price-to-earnings growth ratio (PEG). This ratio compares the price to the rate at which earnings are increasing. Unlike the price-to-earnings (P/E) ratio, PEG is a more accurate representation of company performance over time, rather than just at a point in time. If the price and earnings growth are equally matched, this metric will be one. Anything higher than that means the price is growing quicker than earnings and may be overvalued.
Tesco currently has a PEG ratio of 4.4 and P/E ratio of 12.4. Considering the P/E, it looks cheap — but the high PEG suggests the price is exceeding earnings growth. This indicates that shareholders trust in the company’s future and expect earnings to keep growing – but that doesn’t mean the price will. By comparison, rival Sainsbury’s PEG ratio is only 1.8, but its P/E ratio is 45. It’s had slow price and earnings growth but still looks overvalued due to recent earnings missing analyst expectations.
Future return on equity
Return on equity (ROE) is critical because it’s the clearest indicator of how well a company is using shareholder equity. ROE is calculated simply by dividing the latest annual income figure by the average equity over a year. Forecasting future ROE is a bit more complex and requires certain assumptions to be made about the company’s continued operations. Still, it’s a worthy consideration.
On average, analysts expect Tesco’s future ROE to be around 18% in three years, up from 15% currently. Considering the average FTSE 100 stock has an ROE of 11%, that looks pretty good to me. Of course, a lot could happen in that time so it’s important to also assess the stability of the industry.
Retail in the UK
The retail industry and grocers in particular are considered defensive by nature. People need to eat even if the economy is struggling, so the industry has historically remained strong. And at 27%, Tesco’s market share is considerable, so it would take a serious issue to derail it. This is up from 25.8% in 2020, despite four years of economic uncertainty and disruption.
Overall, Tesco remains one of my favourite stocks for reliable, long-term returns. That said, I don’t expect the price to reach a 10-year high this year. It’s at the top end of a range it’s been trading in for five years with little evidence to suggest it will rise further. I’m holding my shares for now but if I were looking to buy more, I’d wait until later in the year.
This post was originally published on Motley Fool
