Since hitting a two-decade low of 144p at the end of 2015, shares in the UK's largest supermarket retailer Tesco(LSE: TSCO) have made a steady recovery. At the time of writing, the group's shares are trading at 177p, down around 20% from their 52-week high of 219p.
These gains have come off the back of the retailer's improved operating performance. A little over a week ago the company announced better than expected results for the year to 25 February 2017 with underlying profits up 30% year-on-year to £1.3bn. Overall group sales grew by 4.3% to £49.9bn. Much of the growth in underlying profitability came from Tesco's struggling the UK and Ireland business, which saw underlying earnings jump 60% on an actual exchange rate basis to £803m. Like-for-like sales in the UK & Ireland grew 1.3% in the second half and 0.9% for the year as a whole.
But while these results were impressive for a company that has been struggling to return to growth since 2010, management still has plenty to do before Tesco can claim to have fully recovered from its crisis'. With this being the case, the shares look relatively expensive at current levels.
Assuming the firm can hit City estimates for growth for the financial year ending 28 February 2018, Tesco will earn 9.4p per share on a pre-tax profit of £1bn. At the current share price, these figures indicate the shares are trading at a forward P/E of 18.6, which looks expensive, but when you consider the fact that earnings per share are expected to grow by 40% year-on-year, this valuation is relatively appropriate.
For the fiscal year ending 21 February, 2019 analysts are expecting earnings per share growth of 30%, meaning that the group is trading at a 2019 forward P/E of 13.9.
However, optimistic City forecasts don't count for much unless the company can actually hit the targets. Management is targeting operating margins of 3.5% to 4% by the 2019/20 financial year, up from the current 2.3%. Most of this growth will come from cost-cutting and efficiency gains. As of yet, it's unclear how the acquisition of Booker will fit into this plan, but there's talk of significant synergies between the two companies as they combine under-used assets.
A long time
Three years is a long time, and while management's margin forecasts may seem appropriate today, it's impossible to tell what the future holds for the group and for this reason I'm wary of Tesco's current valuation. The market seems to have placed a high multiple on the shares based on current City forecasts, and this multiple does not leave much room for manoeuvre if the company trips up.
If Tesco suddenly finds its turnaround is harder than expected, the shares could lurch lower as investors reconsider the company's investment case. Put simply, shares in Tesco look expensive at current prices.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Booker. 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.