This P/E Suggests J Sainsbury Is a Hold

LONDON -- The FTSE 100 has risen by nearly 20% over the last six months, and many top shares are beginning to look quite expensive. So 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 relative to its long-term earnings.

Today, I'm going to take a look at the PE10 for award-winning supermarket J Sainsbury (SBRY 0.01%) (JSAIY 0.02%).

Is Sainsbury a buy?
Sainsbury won the Supermarket of the Year award for the fifth time in seven years at the 2012 Retail Industry Awards, but are its shares as attractive as its produce?

Let's start with a look at Sainsbury's current price-to-earnings ratio and its PE10:

My calculations show that Sainsbury's current trailing P/E is 12.3 -- an attractive valuation. However, the supermarket chain's PE10 is 18.5, suggesting that it is quite fully valued against its average earnings over the last 10 years.

Future vs. past earnings
One weakness of the PE10 rating is that it is biased toward past earnings, so it can make companies that have delivered strong growth look expensive. In Sainsbury's case, 2005 and 2006 were disappointing, but years 2010 through 2013 have been impressive, with improved earnings per share, profitability, and market share.

The question is whether the last four years' earnings represent a new norm for Sainsbury. I don't think so; I believe the last 10 years provide a more realistic view of the firm's likely fortunes over the long term.

What's next for Sainsbury?
It's worth noting that Sainsbury's EPS peaked in 2010 and have stagnated since then. I suspect that further progress may be slow: Both Tesco and Morrison are increasing their efforts to compete for market share against a backdrop of high unemployment and a stagnant U.K. economy.

Sainsbury is a hold
In my view, Sainsbury is a hold at the moment -- although dividend investors might consider topping up their holdings, as the firm's 4.4% dividend yield remains attractive and is well above the FTSE 100 average of 3%.

Can you beat the market?
If you already own shares in Sainsbury, 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. Woodford's track record is impressive: If you had invested £10,000 into his High Income fund in 1988, it would have been worth £193,000 at the end of 2012 -- a 1,830% increase! This special report is completely free, but availability is limited, so click here to download your copy immediately.