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LONDON -- The FTSE 100 has risen by 25% over the last year, and many top shares are beginning to look quite expensive.
I'm on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I'm using a special version of the price-to-earnings ratio called the PE10, which is one of my favorite tools for value investing.
The PE10 compares the current share price with average earnings per share for the last 10 years. This smoothes out any short-term volatility and lets you see whether a company looks cheap compared to its long-term earnings.
Tesco keeps getting cheaper
Tesco's share price is down by more than 9% from its mid-May peak, although the FTSE 100 has only fallen by 5.9%. Tesco's underperformance is mainly due to a downbeat interim statement last week, which showed that U.K. like-for-like sales fell by 1% in the first quarter of this year.
I think that falling sales remain the biggest hurdle to the credibility of Tesco's turnaround plan, but one quarter's sales are not really that significant, so in my view Tesco's shares are more attractive than they were a month ago, thanks to the price fall.
Is Tesco a buy?
Let's take a look at Tesco's current price-to-earnings ratio and its PE10 to see how cheap it really looks:
Tesco's trailing P/E is based on its adjusted earnings for 2012/13, which don't take into account the substantial restructuring costs it incurred last year.
City analysts are forecasting a 9% drop in adjusted earnings for this year, placing Tesco on a forward P/E of 10.6, with a prospective yield of 4.4%.
Although Tesco's PE10 of 15.1 is not an obvious bargain, it's below my rule-of-thumb threshold of 16, and is noticeably cheaper than Sainsbury, which currently has a PE10 of 17.6.
It's also worth noting that until this year, Tesco had delivered at least 10 consecutive years of rising earnings per share. I reckon that this consistency remains attractive, a view shared by billionaire value-investing legend Warren Buffett, who increased his stake in Tesco to 5% when the firm's troubles began last year.
However, I think Tesco's ongoing sales decline means that its shares are fully priced at the moment, so I rate Tesco as a hold.
Can you beat the market?
If you already own shares in Tesco, then I'd strongly recommend that you take a look at this special Motley Fool report. Newly updated for 2013, it contains details of top U.K. fund manager Neil Woodford's eight largest holdings.
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