When a company is growing profits and its share price, it is usually fairly easy to value the business the faster the company is growing, generally the higher the P/E ratio will be.
But what if the companys profits and share priceare falling? When is thefirm cheap, and when is it expensive? Thats a much more difficult question to answer.
An incredible fall in profitability
Take Tesco (LSE: TSCO). This used to be one of the worlds leading retail chains, churning outhigher profits each year. In 2007 the companys share price peaked at 488p, but then fell steadily, reaching 165p late last year. Thats quite a fall. Since then, the share price has risen to 242p.
So are the shares now cheap or expensive? Is it time to load up on Tesco stock, or will the businesss valuation fall lower? Is the firm a contrarian play or a value trap?
Well, lets look at Tescos recent and predicted earnings per share:
Considering that this has been one of the stalwart blue chips of the FTSE 100, popular with small investors, fund managers and pension funds,thats an incredible fall in profitability. Yet, interestingly,the turnover of the firm has scarcely fallen at all from 2012 to 2016.
To turn around the supermarkets, you need to turn around their margins
This means that the profit marginsof supermarkets such as Tesco, Sainsburys and Morrisons are tumbling. So, whether you think Tesco is cheap or expensive depends upon whether you think it can rapidly recover its margins, or whether the supermarketshave now reacheda new era of greater competition and lower profits.
My feeling is that Tescos profitability, and its share price, can be turned round. After all, surely this was the reason why the firms executives hired Dave Lewis, who helped turn round Unilever in impressive style.
But the lessons we can learn from the chief executives experience with Unilever is that these corporate transformations take time. I think it willtake several years to see Tescosmargins, profitability and share price recover.
Somyopinion isthat Tesco will eventually be a contrarian play, but investors will need tobe patient. My view is over the rest of this decade, rather than just over the next few months. The share price will fluctuate from week to week and month to month, but you need to takea long-term view with this company.
Thats why I would rather wait a few years to see how things pan out. I think Tesco is a contrarian buy, but I wont be investing just yet.
Looking beyond weekly and monthly fluctuations to see what the prospects of a company are years, and even decades, into the future is key to successfullong-term investing.
We at the Fool have analysed global trends to pick a series of sharesthatwe think you can hold until your retirement.
Do NOT buy these stocks
Theres lots of opportunity out there in todays market but theres also PLENTY of danger.
In anticipation of Champion Shares PROs brief opening to new membership a few short weeks from now, the analyst team behind the Motley Fools most exclusive service has agreed to share 3 stocks they believe YOU would do best to avoid.
PRO research is rarely made available to the general public. To find out the names of these “don’t buy” companies — and to claim your 100% FREE copy of Steer Clear Stocks right away — simply click here.