News that the Serious Fraud Office (SFO) is launching a formal probe into the Tesco (LSE: TSCO) accounting scandal seems like another blow that existing shareholders dont need when they are down.
However, those not currently invested, and who may be of a contrarian persuasion, could be rubbing their hands in anticipation, because investing against the flow means that best results can arise by investing when a companys news flow is at its worst.
Down but not out?
Theres no doubt that things are bad in Tescos business. Tescos own new boss, Chief Executive Dave Lewis, reckons Tescos business is operating in challenging times, and that trading conditions are tough. However, thats the least of the firms worries. Mr Lewis candidly adds that Tesco has no competitive advantage in its largest market, the UK, the firm suffers from a weak and vulnerable balance sheet, the enterprise has no trust from its customer base and, hitherto, the company had poor corporate governance.
The accounting scandal, and the SFO investigation, top out that list of very serious issues. Yet, I think the formal investigation could end up being, well, just a formality, which could imply that the worst news is now out, and contrarian investors may be right to run the numbers on Tesco right now.
After all, when others expect us to excel, its hard to admit failure. Have you ever been there? I have, and it can lead to some fuzzy decision-making. Perhaps thats whats behind Tescos accounting scandal. Either way, the Serious Fraud Office intends to find out, but lets not forget that eight executive heads have already rolled over the affair, perhaps heads full of poor judgement rather than heads stuffed with criminal intent
So, whats Tesco worth now?
If we look at the numbers, and just the numbers, Tesco looks as if its priced around fair value. At the current share price around 172p, theres a forward P/E rating of about 10 for year to February 2016 and a forward dividend yield of 3.6% or so.
Tesco moved to rebase the dividend down earlier this year and forward earnings predictions see the payout covered about 2.7 times.
The problem surrounding such typical valuation methods based on earnings is that earnings are slipping. Year to February 2015, earnings per share seem set to come in 44% down, and year to February 2016, City analysts expect a further 5% decline.
Looking beyond the numbers, theres a fair amount of evidence to suggest that Tescos entire business model, and its very trading philosophy, could be holed below the water. Recovery here could well depend on complete change, rather than restoration measures, which seems likely to involve asset shedding and contraction. Such measures could easily affect Tescos earning potential, making valuation-by-earnings a moving target.
So we look to the value of assets as reference. With the recent interims, the balance sheet revealed that Tescos net tangible asset value stands at about 116p per share. In light of that, Tesco still looks expensive!
Contrarian investing looking for a turnaround is a risky strategy. In the face of failure, we must invest for future success. Thats a difficult trick to execute, and history is littered with fallen would-be turnaround investors that weve never heard of.
Injured, Tesco is a dangerous and unpredictable beast right now, so Im going to keep looking for well-performing firms with modest valuations, rather than poorly performing behemoths that could be past their use by dates.
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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK owns shares of Tesco. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.