Don’t Sell Tesco PLC (LON:TSCO) Before You Read This

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Tesco PLC’s (LON:TSCO) P/E ratio could help you assess the value on offer. Based on the last twelve months, Tesco’s P/E ratio is 18.62. In other words, at today’s prices, investors are paying £18.62 for every £1 in prior year profit.

View our latest analysis for Tesco

How Do You Calculate Tesco’s P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Tesco:

P/E of 18.62 = £2.08 ÷ £0.11 (Based on the year to August 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. When earnings grow, the ‘E’ increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.

It’s nice to see that Tesco grew EPS by a stonking 103% in the last year. And its annual EPS growth rate over 5 years is 14%. I’d therefore be a little surprised if its P/E ratio was not relatively high.

How Does Tesco’s P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (18.2) for companies in the consumer retailing industry is roughly the same as Tesco’s P/E.

LSE:TSCO PE PEG Gauge January 9th 19
LSE:TSCO PE PEG Gauge January 9th 19

That indicates that the market expects Tesco will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.

Remember: P/E Ratios Don’t Consider The Balance Sheet

The ‘Price’ in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

Tesco’s Balance Sheet

Tesco’s net debt is 27% of its market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.

The Bottom Line On Tesco’s P/E Ratio

Tesco trades on a P/E ratio of 18.6, which is above the GB market average of 15.2. Its debt levels do not imperil its balance sheet and it has already proven it can grow. So it does not seem strange that the P/E is above average.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’ So this free report on the analyst consensus forecasts could help you make a master move on this stock.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.