The UK’s largest supermarket now offers a 5% dividend yield and trades on a modest 10 times earnings. I think we could see the shares bounce back at some point, perhaps when inflation starts to ease.

If I bought Tesco stock today, how much could I realistically expect to earn over the next five years? I’ve been crunching the numbers to find out. Here’s what I think.

Growth potential?

Tesco currently has a 27% share of the UK grocery market. That means it collects £1 out of every £4 spent on groceries in the UK. Second-place Sainsbury’s is a long way behind, with a market share of 14.7%.

I expect Tesco to remain the UK’s largest supermarket. But I don’t think it will be able to gain much more market share. Despite this, I do expect Tesco to be able to increase its profits over time.

Profit growth could come from some of the group’s other businesses, such as wholesale, mobile, and banking. Profit margins on groceries could also rise if the economic outlook improves and shoppers switch back from cheaper own brands to premium products.

A buying opportunity?

The total investment return from a dividend stock has two elements — dividend income and share price gains (or losses).

Tesco’s dividend last year was 10.9p. I suspect growth will be limited over the next few years as the company tries to maintain dividend growth without paying out more than it can afford.

I’ve assumed average dividend growth of 2.5% each year for the next five years. That would mean I’d receive dividends totalling 57.8p per share over this period. That’s equivalent to a 27% return on today’s share price of 214p.

Of course, I’d also hope to see some share price gains over this period too. One common technique used by analysts to forecast share price growth is to assume that the dividend will increase by the same percentage as the dividend each year.

In my model, this would see Tesco’s share price rising by an average of 2.5% per year — an increase of 13% over five years.

Adding my dividend and share price estimates together gives me a forecast total return of 40% over five years. That’s equivalent to a 7% annualised total return, broadly in line with the long-term average from the UK market.

Tesco shares: a buy today?

Of course, all the numbers I’ve discussed above are only a guess. It’s impossible to predict share price movements and I can’t be sure how Tesco’s dividend will change. Even so, I find this kind of model useful when I’m looking for undervalued shares.

In this case, my feeling is that Tesco looks reasonably valued. In my view, the stock might be slightly cheap, but certainly isn’t a screaming bargain.

I think Tesco’s 5% dividend yield should be pretty reliable over the next few years. But I suspect growth will be limited. For a mix of income and growth, I think there are probably better choices elsewhere.

The supermarket business is challenging

Tesco’s dominance in the grocery sector is not in dispute. But this does not shield it from the larger challenges it now faces. The competition from lower cost rivals such as Lidl and Aldi are well documented. In fact, these chains reportedly are the fastest growing supermarkets in the UK.

Tesco has said in response that it has worked aggressively to close price gaps across a range of products, as well as imposing a price freeze on more than 1,000 items until 2023.

In my view, such efforts to maintain market share can only come at a cost to the bottom line.

Present economic conditions don’t help

While spending money on food is not necessarily considered discretionary, the present cost-of-living crises within a recessionary environment is bound to influence how much we spend. In fact, supermarkets are already suggesting that the coming Christmas period will not be “normal”. Consumer confidence is certainly impacting sales.

Such an operating environment accounts for a 64% drop in profits for Tesco in the first half of 2022, against a backdrop of rising costs, falling margins and inflationary pressures.

So, what is the upside?

I do believe that it is too early to dismiss Tesco as a potential investment for my portfolio. There is room for some optimism.

It is, despite poor trading conditions, on a more stable financial footing than many of its rivals. Its strong cash position implies it is better suited to outlast a price war. Then combine this with its enormous scale of operations and the subsequent buying power it enjoys with its suppliers.

Additionally, it has an effective loyalty system via its Clubcard membership. An impressive 20 million customers benefit from reduced prices on many products. Tesco has achieved this while also being particularly effective at capitalising on the growing online grocery business and now enjoys a 39.5% share in the UK.

Finally, the directors themselves have been buying stock in some volume. This to me indicates a vote of trust in their own company.

Potentially both a growth and an income stock

I do not know when the share price will recover, but I am assuming that most of the bad economic news has already been priced in. In the meantime, Tesco continues to maintain its policy of paying half its profits to shareholders. Presently the dividend yield sits at 5.12 % with a dividend cover of around 2.01. To my mind that could be an acceptable return while I wait patiently for the stock to perform.

After regaining some ground, the Tesco share price now hovers just above 210p. So, would the company make a good addition to my portfolio today?

Here’s my take.

Why have Tesco shares crashed?

Various factors have contributed to Tesco’s poor performance. I’m going to explore three in particular.

First, there’s the cost-of-living crisis. As consumers feel the pinch, there are indications that spending at the firm’s stores is falling, particularly on clothing and general merchandise. To compound difficulties, food inflation is currently running at 14.5% — the highest level since 1980. In response, Tesco has raised the price of its meal deal package from £3.50 to £3.90 as soaring ingredient costs put pressure on already tight margins.

This leads me to another key challenge facing the company — competition. German budget chains Aldi and Lidl have been nipping at the heels of home-grown supermarkets for a while now. As shoppers count the pennies, there are signs competition is intensifying. Recent Kantar research indicates that the duo increased their market share this year following aggressive expansion campaigns over the pandemic.

Finally, Tesco’s vulnerable to currency fluctuations. The business model relies heavily on imports. With the pound trading near generational lows, the company will have to contend with higher supplier costs for the foreseeable future.

Reasons to be cheerful

Despite significant risks, I can find some compelling reasons to invest.

Following recent falls, the stock’s dividend yield has risen to 5.5%, comfortably beating the FTSE 100 index average. Dividend cover looks healthy at 1.9 to 2 times anticipated earnings for the next couple of years. Tesco shares have the potential to be a solid passive income generator for my portfolio in the years ahead, provided the grocery giant can successfully navigate market turbulence in the short-to-medium term.

There are some encouraging signs of financial health. In its interim results, Tesco revealed a £0.5bn net debt reduction. It was also the only one of the UK’s traditional ‘big four’ supermarkets to grow its market share over the past three years.

Admittedly, full-year profit expectations were trimmed to £2.4bn-£2.5bn from the previous forecast of £2.4bn-£2.6bn. However, this could have been worse, and I’m pleased to see updated guidance is still within the previously estimated range, albeit towards the lower end.

Britain’s largest supermarket is also continuing its £750m share buyback programme. It recently appointed HSBC to repurchase shares with a value of up to £100m in the latest tranche. This should act as support for the share price if underlying profits decline.

Would I buy?

I’m tempted by Tesco shares at the current price, but I think there could be further falls ahead, particularly if full-year profits are lower than expected. Ideally, I’d like the stock to revisit its five-year lows below 200p before I start to build a position.

Accordingly, Tesco will take a prominent position on my watchlist, but I won’t be buying at today’s price.

Tesco is the Goliath of grocery

In the past, I owned Tesco shares for many years. But it’s been perhaps a decade since I was an investor in the UK’s biggest supermarket chain. When I sold my stock, the shares were trading around 470p, versus Friday’s closing price 209.2p. Hence, it looks like I dodged a bullet by selling out many years ago. Now I’m thinking about buying back in. Why?

The first thing I like about Tesco is its market leadership and dominance of the UK grocery sector. In the 12 weeks ending 2 October, Tesco had a market share of 27% of the British grocery market. This makes the group the Goliath of UK grocers, even though its market dominance has declined over the past decade.

Of course, being #1 in a market delivers various economies of scale to the business. Tesco’s leadership means that it negotiates with suppliers from a position of strength. This helps the chain to maximise its margins, as well as minimising prices rises for customers. This long-standing resilience is attractive to me as a potential investor.

Tesco shares look underpriced to me

Despite Tesco’s role as the behemoth of British shopping baskets, its shares have had a tough 2022. Here’s how they’ve performed over six timescales:

Over the past 12 months, the Tesco share priced has dived by almost a quarter. Also, it’s lost more than a tenth of its value over the past half-decade. But these returns exclude dividends, which are a powerful part of this stock’s long-term appeal to me.

However, even Tesco has been hurt by the ongoing cost-of-living crisis. Hence, its shares are well below the 52-week high of 304.1p they hit on 28 January — four weeks before Russia invaded Ukraine. At the current share price of 209.2p, this FTSE 100 stock trades on around 10 times forward earnings and offers an earnings yield of 10%.

However, as an income/value investor, what draws me to this stock is its market-beating dividend yield of 5.5% a year (versus 4.2% for the wider FTSE 100). It’s worth noting that Tesco recently raised its half-year dividend from 3.2p to 3.85p a share, a juicy increase of 20.3%. Also, the ongoing £750m share-buyback programme will lift future earnings per share by shrinking the shareholder base.

I’ll buy Tesco soon

While I’ve no doubt that 2023 will be a really rotten year for UK consumers, my aim is to buy shares in Tesco to hold for, say, the next decade. Hence, if the price weakens again, then I’ll probably jump aboard. Also, I expect Tesco’s retail sales (and projected yearly free cash flow of £1.8bn) to rise over time. And I’m hoping that this will translate into higher returns for patient shareholders, including me!

The Tesco (LSE: TSCO) share price is down. But does the company now make a good stock investment? The directors seem to think so. Some of them have been buying the shares for themselves in October. And I don’t blame them.

Cash flow holding up

A year ago, Tesco made a big statement about the value it sees in its own business by starting a £750m share buyback programme. I reckon the move demonstrates that a healthy flow of cash is still coming into the business. And strong cash flow is one of the main reasons I’d consider buying some Tesco shares. It takes cash to pay shareholder dividends. And, to me, an investment in the company is all about dividend income. 

But previously, the biggest requirement for me to get interested in the stock was a dividend yielding at least 5%. I’ve always wanted a big shareholder payment to compensate me for some of the risks of holding the shares. But for a long time, the valuation looked too high for my tastes and the yield too low.

However, the situation changed between mid-August and now when the share price plunged by around 25%. And the current level near 205p puts the company back on my watchlist. To put the move in perspective, the 25% decline is also how much lower the stock is over the past year. 

Lower earnings

My guess is the slide occurred because of lower earnings. The company issued its half-year results report in early October and the figures revealed how tough trading has been for the supermarket chain. Profits, earnings per share and cash inflow were all down year on year. But, crucially, the directors raised the interim dividend by just over 20%.

I reckon that move underlines the directors’ confidence in the outlook. And seeing some of them put their own money on the line with personal share purchases reassures me even more. 

However, positive long-term outcomes are never certain with stocks and shares. The signs look good to me with Tesco, but any business can suffer operational setbacks at any time. And I’m not forgetting the business got itself into trouble a few years back and had to turn itself around. I’m also mindful that the supermarket sector is competitive and the business is low-margin in nature and carrying a lot of debt.

Uncertainties ahead

In the interim report, chief executive Ken Murphy guided the market to expect full-year operating profit at the “lower end” of previous expectations. He said: “Significant uncertainties in the external environment still exist, most notably how consumer behaviour continues to evolve.”

I’m not expecting the Tesco share price to shoot the lights out in the years ahead. But I am hoping for the business to keep defending its position in the market against its many competitors. 

Times are tough. But even now the firm is turning a profit. And earnings cover the dividend payment around twice. My assumption is the company will keep on paying dividends and grow them a little each year. And, as such, I reckon the stock is a candidate for my diversified income-focused portfolio when I next get some spare cash.

1. Resilient long-term demand outlook

The first thing I consider when valuing a business is how big the potential market is for it now and in the future. In recent years this has come to be known as a company’s “total addressable market”. That is the market size a firm operates in, both for it and all its potential competitors.

In this regard, I think Tesco looks very attractive. No matter how trends or economic circumstances change the way we live, people will need to eat and drink. I expect robust long-term demand for groceries and the variety of items Tesco sells. That should be good for its future revenues. Last year, its sales were over £1bn a week on average.

2. Strong market position

One risk I see however, is profitability. Big sales do not always equal big profits. Supermarkets have long generated high sales volumes but relatively low profit margins.

The increase in online shopping could make this worse, I reckon. New entrants might see an opportunity to seize market share by discounting, hurting profits for established operators like Tesco.

The economics also look less attractive to me. In bricks and mortar retailing, customers pick and pack goods themselves. In the digital version, by contrast, doing that requires staff or robots – another cost for the retailer.

Set against that though, is the second strength I see in Tesco – its well-established brand. It is the nation’s largest retailer and has a massive customer understanding, thanks to its Clubcard loyalty scheme.

That can help it keep customers and maintain profits in store. But I also think it gives it a competitive advantage online that might help it adjust its digital business model to maintain profitability. That could be good for Tesco shares.

3. Free cash flow potential

I also like the free cash flow potential of a company like Tesco. In its interim results this month, the company reported free cash flow in its retail business of £1.3bn. Over the long term, I expect the business to continue to throw off substantial amounts of excess cash flow that can be used to fund dividends. Currently, the dividend yield is 5.7%.

Why I’m not buying Tesco shares for my pension

That dividend yield certainly tempts me as an investor. But the long-term share price movement at Tesco has been less than compelling, in my view.

When investing for my pension, I have time on my side. So although I like the income potential of Tesco shares, I am less excited by the share price growth prospects – especially if increasing online competition squeezes profit margins.

I do think Tesco could be a good long-term investment for me. But I do not think it is likely to be an ideal one. For those reasons, at least while I see great opportunities elsewhere in the current market, I have no plans to add Tesco to my pension portfolio.

Price fall

The Tesco share price has fallen 25% over the past 12 months.

A price fall alone is not a good reason to buy shares. But when there’s nothing wrong with the company behind it, it can be. And a company that’s strong enough to withstand short-term economic upsets can be a long-term bargain buy when it’s down. Is Tesco such a company? I think so.

Big dividends

The share price fall has pushed up the Tesco dividend yield. Forecasts suggest 5.6% for the current year.

If we buy a long-term dividend stock when its price is down and its dividend yield is elevated, that can provide a lifelong benefit. With every share we buy today, we can lock in all future dividend yields, based on the price we pay now.

I don’t know what might happen in the short term. But if Tesco maintains strong dividends for decades, it’s surely good to buy when the shares are low and the yield is high.

Share buybacks

Tesco is continuing its £750m share buyback programme with a new £100m tranche. I like a share buyback for several reasons. It should boost future dividend yields. That’s because the same amount of cash would be spread over fewer shares. It also shows that the company has the cash to spare, lessening my concerns over its long-term health.

A buyback can help support the share price too. But I’m maybe less happy about that, as I’d prefer to buy at an even lower price.

Inflation protection

Inflation pushed above 10% in September. How do investors cope with high inflation? One way is to invest in companies providing essential goods and services, as they’re less likely to be hit by restricted spending.

And what better than the nation’s biggest food retailer? It ties in with Tesco’s underlying strength, and with those dividends. I reckon the best way to deal with inflation is by snagging lower-risk dividends that can beat it in the long term.

Pessimism

Finally, just a reason to buy shares in general now. Famous fund manager Sir John Templeton once said “The time of maximum pessimism is the best time to buy.” Billionaire investor Warren Buffett has famously urged us to be “greedy when others are fearful.“

Are investors fearful? Are we seeing maximum pessimism now? I think it’s a great time to buy shares.

And reasons not to buy

There are reasons not to buy too. Tesco has been forced to cut prices to remain competitive against the likes of Aldi and Lidl. And a recession of any length could keep that pressure on for a lot longer than we’d like. And we could easily see further share price falls over the next couple of years.

Tesco also carries £10bn in net debt. During the Covid crisis, we saw the damage that some debt-laden companies suffered. Might Tesco’s debt be damaging in a recession?

Still, I think the balance is favourable for long-term investors. And Tesco is on my list of candidates (along with quite a few others, mind).

Would I buy Tesco shares for my own portfolio today? I would, if I was looking to boost my exposure to defensive UK stocks. Here are three reasons why.

Directors have been buying shares

One thing that stands out to me here is that directors at Tesco have been buying stock recently. On 5 October, the CEO, the CFO, and the chairman all snapped up shares. Then, a few days later, board member Byron Grote purchased stock. Combined, these four insiders bought around £250,000 worth of Tesco shares.

I see this buying activity as a positive development. Insiders have more information on a company than anyone else. They don’t buy company stock if they expect it to go down. These purchases indicate that those within the business believe the stock offers value right now.

Tesco is buying back its own shares

Another thing to like about Tesco is the fact the company is buying back its own shares. Previously, it announced a £750m share buyback programme and, last week, it gave HSBC the green light to repurchase £100m worth of shares on its behalf, as part of this overall programme. This also suggests management believes the stock offers value right now.

Share buybacks are positive because they reduce the number of shares on issue, which leads to higher earnings per share. This can help support a company’s share price.

There’s a big dividend on offer

Finally, there’s the big dividend yield. After the recent share price fall, Tesco’s prospective yield now stands at around 5.1%. I think that’s hard to ignore in the current environment. Dividend coverage (the ratio of earnings to dividends) is solid at around two times, which indicates that the chances of a dividend cut are quite low.

On the topic of dividends, it’s worth pointing out that Tesco recently hiked its interim payout by 20.3%. This large increase indicates that management is confident about the future.

Attractive risk/reward

Now, of course, there are risks to consider here. One is competition from Aldi and Lidl. With consumers looking to cut costs, Tesco could potentially lose market share to the discount players in the years ahead.

Another risk is debt. At the end of February, Tesco had net debt of £10.5bn on its balance sheet. This is not ideal in a rising interest rate environment. Higher interest payments could hit profits.

However, with the stock currently trading on a forward-looking P/E ratio of less than 10, and offering a 5%+ dividend yield, I like the risk/reward proposition here. So I’d be comfortable taking a small position in Tesco today.

The case for a continued fall

Straight off the bat, I think it’s unlikely that the share price will hit 100p given that it hasn’t traded below 150p in the last decade. However, this doesn’t mean that a continuation of the recent fall might not happen.

The main driver that could cause this would be lower consumer demand due to price inflation. Not only this, but it’s a deadly cocktail for Tesco even if it doesn’t pass the price hikes onto the end customer. While absorbing those costs would help to keep demand high, it would reduce profit margins if the company took the hit instead.

Given that the business operates on razor thin profit margins (in the single-digit percentages), spiralling inflation could easily push the firm into making a loss. In this case, a tumble in the share price would be logical as investors digest this news.

Its latest half-year profits were down 63.9% versus the previous year, with inflation a key issue. In order for the price-to-earnings ratio to be a fair value, a fall in earnings usually corresponds to a fall in the share price in the long run.

Why we could see Tesco shares rally

In the interim results released earlier this month, it was made clear that the business knows what to focus on. It’s trying hard to retain customers through initiatives related to price. These include promotions such as the Aldi Price Match, Low Everyday Prices and Clubcard Prices.

As a result, statutory revenue for the half-year was £32.5bn, up 6.7% on the same period last year. I think this speaks volumes. Even with people tightening their belts, Tesco is still able to grow revenue.

The year high of 301p in Q1 does seem a long time ago. But when I consider if 100p or 300p is more likely going forward, I have to pick 300p. On the basis of strong residual demand and inflation normalising over the next year, profitability should be much stronger in 2023.

Aside from reporting better finances, the other element that could push Tesco shares higher is better investor confidence. With all the issues swirling around at the moment, I feel the share price has dropped in part due to some investors selling stocks in general and holding cash. I’m not criticising it, but ultimately when we’re past the worst of it, I think the stock could rally as long-term investors spot it as a value play.

Overall, I’m thinking about buying Tesco shares as I think the potential reward is higher than the current level of risk.

Up and down

Imperial’s shares are up 21% year to date. Tesco’s are down 31%.
 
The theme continued on news from the two companies last week. A trading statement from Imperial produced a 2.5% rise on the day, while Tesco’s half-year results provoked a 4.1% fall.
 
Why the contrasting fortunes? And where will the stocks go from here?

Imperial in line

Imperial updated on its performance for its financial year ended 30 September. It said trading had been in line with its previous guidance. And that it expects to report full-year net revenue and adjusted operating profit growth of around 1% at constant currency.
 
Management also reiterated guidance for the next three years. It continues to expect low single-digit constant currency net revenue growth, with adjusted operating profit accelerating to deliver a mid-single digit compound annual growth rate over the period.

Improving returns

Imperial said it’s completed the two-year ‘strengthening’ phase of its five-year strategic plan, announced in January 2021. And is now moving into the next three-year ‘improving returns’ phase.
 
In addition to the existing “progressive dividend policy,” the company has started “an ongoing, multi-year share buyback programme” with immediate effect.
 
This means investors who stick with the company for the long term should not only receive a flow of rising dividends, but also an increasingly larger slice of the ownership of the business. All being well.

Deep in value territory

As I’m writing, Imperial’s shares are trading around the £20 mark, compared with a 52-week low of nearer £14. Buyers of the stock today are paying 7.6 times the earnings expected in the full-year results. The dividend yield is 7.1%.

Despite the strong rise in the share price this year, the earnings multiple and yield remain deep in traditional ‘value’ territory.

Tesco sets out its stall

Tesco reported a constant currency 3.5% rise in sales (excluding VAT and fuel) in its first-half results for the six months ended 27 August. However, adjusted operating profit was down 9.8%.
 
The company said the lower profit was due to the impact of reduced year-on-year volumes (as a result of a post-pandemic normalisation of trading), cost inflation and keeping the price of the weekly shop as affordable as possible for customers.
 
Tesco unwisely took its customers for granted during the hard times of 2008/09. I reckon the current strategy of doing its best for them — at the cost of lower profit margins — is the right way to go for the longer-term good of the company. 

Guidance

Despite the headwinds, management maintained its retail adjusted operating profit guidance for the full year within its previous range (£2.4bn-£2.6bn), although pulled it to the lower end: between £2.4bn and £2.5bn.
 
More positively, it upgraded its retail free cash flow guidance (previously £1.4bn-£1.8bn) to “at least £1.8bn.”
 
Nevertheless, the board also cautioned that “significant uncertainties in the external environment still exist, most notably how consumer behaviour continues to evolve.”

Valuation

Tesco’s share buyback programme, which started in October last year, hasn’t done a lot to support the share price. As I’m writing, the shares are trading near to £2, compared with a 52-week high of around £3.
 
On the plus side, this means Tesco’s been able to buy back a lot more shares at a lot lower prices as the year’s gone on.
 
Buyers of the stock today are paying 9.3 times the company’s trailing 12-month earnings. And the running dividend yield is 4.2%.

At the checkout

Tesco’s earnings multiple is higher than Imperial’s and its dividend yield is lower. However, the supermarket’s rating is by no means rich.

If you believe — as I do, and the company’s management does — that Tesco has “the right long-term strategy,” you may well be inclined to see value in the stock today.

Meanwhile, despite a strong share-price rise and perennial worries about the future of the tobacco industry, Imperial’s earnings multiple and dividend yield continue to look attractive to my eye.

I’m only sorry I didn’t buy the stock this time last year when our Motley Fool Share Advisor analysts identified it as their top pick for income and growth.