This Ratio Gets Me All Excited About Tesco PLC

The Motley Fool

Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) is, in my view, a screaming buy.

Although the company continues to experience challenging trading conditions across Europe and in parts of its other international business, I feel that shares offer good value for money at current levels.

Indeed, the attraction of the shares is perhaps best exemplified by looking at the price-to-book ratio, which measures the premium above net asset value at which shares are currently trading.

In Tesco's case, this ratio is relatively low at 1.75 and shows that investors are not required to purchase a large amount of goodwill when buying a stake in Tesco.

This is good news because it means that investors are able to buy the net assets of Tesco plus a relatively small premium to account for the profit-generating capabilities of those assets when, in my opinion, those net assets are capable of delivering higher profits that they currently are, meaning the goodwill element of Tesco's valuation should be higher.

In addition, Tesco continues to invest heavily in the business, with its online and convenience store offerings both delivering impressive growth. Therefore, I'm in favour of the generous level of capital expenditure that the company continues to incur, with the focus of the spending rightly being on the higher growing areas (such as online and convenience stores) rather than on the slower growing areas (notably hypermarkets).

Ultimately, such spending will be to the benefit of shareholders as a result of a higher net asset value.

Furthermore, I believe there is the potential for Tesco to increase its payout ratio, giving income-seeking investors like me an even better yield.

For instance, the payout ratio (using adjusted earnings) was just 41% last year. This is relatively low and, although Tesco needs to continue to invest in the business, I feel that a payout ratio of 50% or even 60% is possible. This would provide a turbo boost to the yield and help to keep inflation at bay.

So, a low price-to-book ratio has made me optimistic about Tesco as an investment, and I feel that the company's balance sheet has the potential to deliver more profits than the current valuation suggests.

In addition, the high levels of capital expenditure and the potential for a higher payout ratio are also big positives, with the latter being of great interest to income investors like me.

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