Valuation of Shares: TESCO plc - Term Paper Example

Valuation of Shares - TESCO plc. TESCO is the largest grocery retailer in the UK. For the financial year ended February 2007 it reported world-wide group gross revenue in excess of 42 billion. TESCO operates in a number of countries across Europe and Asia and also in the United States. The TESCO ordinary share of 5p is currently traded on the London Stock Exchange at 424.75p (January 18, 2008 close) with a 52 week high of 494.25p and low of 392.00p. While some of the fluctuation in the share price may be ascribed to the fluctuation in the overall market (as demonstrated later) the changes are largely based on the different reports emanating in the media about the company's performance and the opinions offered by different 'gurus'. This report analyses the behaviour of the stock in the past five years, links it to the financial performance of the company and predicts the future trend that may emerge. This report also analyses the value of the TESCO share as an instrument for investment in absolute terms. Different tools are available for making financial analysis of stocks and range from the very simple and elegant to the very complex and difficult to understand ones. Here we use some of the most recognised analysis methods such as Earnings per Share (EPS); Price to Earnings Ratio (PE); Cash Flow Discounting; Market Value; and Book Value. Share Price Evaluation: The financial performance of the company is better understood through the calculation of some important ratios that assist us in further detailed appraisal. (These ratios are calculated from the summary financial performance sheets placed at Enclosures 1 and 2.) 1. Accounting ratios: 1.1 Financial structure: Some of the important ratios are: a. Acid test ratio (quick ratio) = (current assets - stock) / current liabilities {Expressed as a percentage} This is a more severe test of liquidity than the Current Ratio as it excludes the least liquid portion of current assets, stocks. 2003 2004 2005 2006 2007 2007-08 Total Current Assets 2440 3125 3224 3919 4576 4810 Total Inventory 1140 1199 1309 1464 1931 2091 Total Current Liabilities 5372 5516 5680 7518 8152 9258 Acid Test Ratio 24.20% 34.92% 33.71% 32.65% 32.45% 29.37% This is on par with the industrial average of 33% for the year 20061 b. Long-Term leverage ratio = (Long-term Debt/Net Worth) {Expressed as a percentage} This ratio helps us understand the relative importance of long-term debt in the capital structure and can therefore provide useful additional information for assessing the acceptability of the overall leverage position of the business. 2003 2004 2005 2006 2007 2007-08 Long Term Debt 4034 4346 4563 3742 4146 4588 - Total Assets 16501 18520 20155 22563 24807 26433 - Total Liabilities 9985 10522 11552 13183 14301 15738 Net-Worth 6516 7998 8603 9380 10506 10695 L.T. Leverage Ratio 61.91% 54.34% 53.04% 39.89% 39.46% 42.90% The long-term leverage of the company is good and shows a positive and reducing trend over the period considered. Indicating that the long term debt is coming down and this will impact future interest burden as well as allow the company to raise further funds in the debt market, should they be required. c. Interest cover = operating profit / interest charges This shows the number of times available profit covers interest charges and measures the extent to which operating profit can fall without being insufficient to cover the interest charges and thereby create a pre-tax loss. 2003 2004 2005 2006 2007 2007-08 Operating Profit 1361 1600 1943 2235 2653 1289 Interest Expenses 227 258 235 241 216 20 Interest Cover (Times) 6.00 6.20 8.27 9.27 12.28 N.R.2 The effect of the lowering debt resulting in lowering of the interest burden is clearly evident in these numbers. The company appears to have no problem in servicing its debt, the numbers compare very favourably with the industry average of 3.29. 1.2 Operating performance: The ratios that are relevant are: a. Return on Capital Employed (also known as the primary ratio) = Operating Profit / Capital Employed {expressed as %) The ROCE is similar to Returns on Assets except that the profits are related to the Total Capital Employed. The term Capital Employed refers to long-term funds supplied by the lenders and owners of the firm. It can be computed in two ways. First, it is equal to non-current liabilities (long-term liabilities) plus owner's equity. Alternatively, it is equivalent to net working capital plus fixed assets. This ratio is the most important measure of the overall efficiency of the management of the business because it relates the result of operations to the total funds being used in the business. It sheds more light on the criticality of gearing and, when compared with the acid test, gives an idea as to the candidate's vulnerability to take-over and bankruptcy. Return On Capital Employed 2003 2004 2005 2006 2007 2008 Operating Profit 1505 1787 2001 2280 2648 1309 Capital Employed - Fixed Assets 14061 15395 16931 18644 20231 21623 - Current Asset 2440 3125 3224 3919 4576 4810 - Current Liabilities 5372 5516 5680 7518 8152 9258 - Capital Employed 11129 13004 14475 15045 16655 17175 ROCE 13.52% 13.74% 13.82% 15.15% 15.90% 7.62%3 The management of TESCO has produced results that are better than the industrial average of 10.44 (for 2006) and the average for the past five years (14.77%) also is a drastic improvement of the industry five year average of 7.31%. (Note: the TESCO average is for 5 years up to Aug 2007 and the industry average is up to Dec 2006, the latter is bound to improve as results come in). b. Return on total assets = operating profit / total assets {Expressed as percentage} This ratio measures the overall efficiency with which assets are being utilised. 2003 2004 2005 2006 2007 2007-08 Operating Profit 1361 1600 1943 2235 2653 1289 Total Assets 16501 18520 20155 22563 24807 26433 Return on Total Assets 8.25% 8.64% 9.64% 9.91% 10.69% 4.88% For the year ended December 2006 Industry average is reported at 6.96 and the average for the past five years is 5.17. Gross profit ratio (margin) = sales less cost of sales / turnover {expressed as a percentage} This ratio is an indicator of the efficiency of the operations of the business as distinct from the selling and general management areas. 2003 2004 2005 2006 2007 2007-08 Revenue 26004 30814 33866 39454 42641 22631 Cost of Goods Sold 24444 28925 31231 36426 39401 21017 Margin 1560 1889 2635 3028 3240 1614 Gross Profit ratio 6.00% 6.13% 7.78% 7.67% 7.60% 7.13% Average for the past five years is 7.26 percent. The current margin of 7.13 percent; as well as the average does not compare favourably with the industry averages of 7.73 and 10.13 percent respectively. Operating Margin (Operating Profit Ratio) = profit before interest and tax / turnover {Expressed as a percentage} 2003 2004 2005 2006 2007 2007-08 PBIT 1505 1787 2001 2280 2648 1309 Turnover 26004 30814 33866 39454 42641 22631 Operating Margin 5.79% 5.80% 5.91% 5.78% 6.21% 5.78% The previous year's result is marginally better than the Industry average of 5.55%. Average operating margin for the past five years (5.90%) is also an improvement over the industry average of 4.67%. Similar comparisons on the basis of profit margins yield similar results for TESCO. The above clearly demonstrates that while the gross margin is weaker the net margins are an improvement over the industry averages - A clear indication of the effects of economies of scale and, perhaps, tight management control on costs. Examination of some of the critical ratios and comparison with the industry (grocery retail) have evidenced that TESCO is in a financially stable situation and needs to maintain present levels of performance to remain competitive in the market. We now shift our focus to the ratios that are more important from the investors' point of view. 3. Investment Ratios Earnings per Share The EPS method looks at the financial performance of the company; focussing on the earnings recorded per share. These numbers provide a clear picture of the actual profitability of the company. A summary of TESCO's consolidated financial results for the past 5 years and the (to-date) 2nd quarter (half year ended August 25, 2007; 26 weeks) of 2007-08 is placed at Enclosure - 1 to this report. The highlights are given below: Year Ending Revenue (m) Net Income Norm. Income pre-Tax Norm. Income Ex-Tax Shares EPS EPS Growth 28-Feb-03 26,004 946 1395 976 7051 13.842 28-Feb-04 30,814 1100 1661 1160 7368 15.744 13.74% 28-Feb-05 31,231 1344 1845 1318 7804 16.889 7.27% 28-Feb-06 36,426 1570 2158 1531 7932 19.302 14.29% 28-Feb-07 42,641 1892 2338 1658 8038 20.627 6.87% 31-Aug-07 22,631 936 1289 936 8032 11.653 12.99% (Note: Calculation for the 2007-2008, is based on a simple multiplication of the first half results by 2) Tesco has achieved substantial growth over the five years to February 2007. The total revenues have increased with group turnover increasing by 64 per cent, and group operating profit by 100 per cent. The increase is 70% on a normalised basis after tax. Growth trend is seen continuing through 2007-08. However, it is the Earnings per Share (EPS) growth that shows an interesting behaviour. The EPS growth appears to be cyclical with alternate years recording highs and lows varying between a high of 14.29% in the financial year (FE) ended February 2006 and a low of 6.87% recorded for FE ended Feb 2007. The group was following the UK GAAP accounting practice up to 2004 and then switched over to the IFRS. Detailed examination of the accounts from different aspects does not reveal any accounting difference in these years and treatment of all items appears fair, sound and uniform. Therefore, it can be inferred that the reason for the periodical fluctuation of the EPS is due to the inherent nature of the business cycle or management practices of treatment of certain areas of accounts. This is of primary interest to the stock holder or a prospective investor; for if the trend is followed in the future also then the EPS for FE ending February 2008 will be high (as already indicated by the 12.99% recorded in the first six months operation results). But, the following year will show a lower EPS and this will impact share prices in the stock market. Price to Earnings Ratio This ratio is the market price of the share compared with earnings per share. Since the share price changes almost continually the ratio also keeps changing all the time. The real time PE ratio for TESCO has been calculated on the basis of the share price of January 18, 2008 (close). The share was trading at 424.75p per share. The earnings per share are at 23.306p/share (Based on the half year results x 2) This translates to PE ratio of = 424.75/23.306 = 18.22 This is the most important ratio used by the market generally to assess the relative rating of a share and the candidate's prospects and, of course, is the easiest to understand. It identifies the number of years' earnings needed to cover the current market price of the share. Some investors prefer to use 'Earnings Yield' which is the inverse of the PE ratio, therefore the earnings yield for TESCO calculated in real time on January 18 quote on the LSE is 5.49%. Dividend yield Investing in shares does not depend on the dividend payments, but rather the investor's perception of the future share price movement. This ratio is calculated on dividend per share divided by its market price. Real time (January 18, 2008) = 9.64 (dividend for FE ended Feb 2007)/424.75 = 2.27% This is the actual yield currently available on investment in the share at the current market price. 4. Equity Valuation Cash flow discounting-based method This method is used to determine the value of the company by estimating the cash flows it will generate in the future and discounting them at a discount rate matched to the flows risk using the free cash flow to equity discount rate. First Estimate We begin by estimating a normalized free cash flow to equity for the current year. To estimate net capital expenditures, and working capital requirements we will use the average capital expenditures and working capital change between 2005 and 2007 (to smooth out the year-to-year jumps) and the depreciation from the most recent year. The present book debt ratio of the company is 0.54 (Total Debt = 5700; Total Equity = 10506) we assume that the company will retain the same ratio in the future also. This implies that 54 percent of future reinvestment needs will come from debt and the balance from internal accruals. In order to estimate the expected growth rate in free cash flows to equity (FCFE) we need to compute the FCFE in the current year (2007). Net Income for the year = 1881 million Pounds Net Capital Expenses x (1-Debt Ratio) = (960) x (1- 0.54) = 442 (Net Capital Expenses = Average of (427, 1361 and 1094) Change in Working Capital X (1-Debt Ratio) = (395) x (1- 0.54) = 182 (Change in Working Capital = Average of (65, 1143, and -23) Normalised FCFE for the current year = 1126m Equity Reinvestment Rate = 1-(FCFE/Net Income) = 1- (1126/1881) = 40.1% Return on Equity = 1658/10506 = 15.80% The expected growth rate in FCFE is a product of the equity reinvestment rate and the return on equity. Thus, expected growth rate in FCFE = 0.401 x .1580 = 6.34% To estimate the cost of Equity, we use the bottom-up un-levered beta for the company 0.864, The TESCO market debt to equity ratio of 129%* and a tax rate of approx 30% Levered Beta = 0.86 (1 + (1-0.30) (1.29) = 1.88 * Ratio between: Market Debt 8152 and equity of 10506 Using a risk-less rate of 4% based upon a 10-year denominated bond issued by the Government, and using a risk premium of 4% (4% for mature market risk plus 0% for any additional country risk), we estimate a cost of equity: Cost of equity = 4 + 1.88 x (4) = 11.54% With the normalized FCFE estimated above, a perpetual growth rate of 6% and a cost of equity of 11.54%, we can estimate the value of equity below: Value of equity =Expected FCFE next year/ (Cost of equity - Expected growth) = 1126 x 1.06/ (0.1154 - 0.06) = 21544 mil Common Shares of the company = 394 mil @ 5p each = 7880 mil shares Value of each Share = 21544/7880 = 273p. Second Estimate: To make a more accurate valuation of the equity the perpetual growth model used above is of limited value. The Two-stage FCFE Model is better for more precise estimation of the value of a company's equity. We will assume that net capital expenditures and working capital will grow at the same rate as earnings and that the firm will raise 54% of its reinvestment needs from debt (which is its current book value debt to capital ratio). In stable growth (after 3 years of, say, 9% growth), we assume a stable growth rate of 4%. We also assume that the cost of equity remains unchanged but that the return on equity drops to 10%. The equity reinvestment rate in stable growth can be estimated as follows: Equity reinvestment in stable growth = g/ROE = 4%/15.8% = 25% The first component of value is the present value of the expected FCFE during the high growth period, assuming earnings, net capital expenditures grow at 9% and 54 % of reinvestment needs come from debt. Working capital growth will be negative during the three years period and current assets/current liabilities ratio will further decrease at pace equal to the 13% (calculated as medium historical rate) EPS - 18.9 (calculated average of previous three years) Net Capital Expenditures adjusted for debt ratio/share = 5.6p Current Revenues = 42641mil Revenue/ share = 541p Change in Working capital adjusted for debt ratio = 182 mil Chg. Working Capital/share = 2.31 p EPS 20.6 24.3 30.9 Net Capital Expense 6.1 7.2 9.1 Change In WC per Share 2.5 2.9 3.8 FCFE per Share 15.6 18.4 23.3 Present Value 14.0 14.9 17.0 The sum of Present Value of FCFE is = 45.9 EPS for the fourth year is = 30.87*1.04 (4%growth) = 32.11 Equity Reinvestment in Year 4 = EPS4*Stable Equity reinvestment rate = 32.11*0.25 = 8.026 Expected FCFE in year 4 = EPS4 - Equity Reinvestment4 = 24.084 Terminal value of equity per share = FCFE4/ (Cost of equity4-g) = 32.11/0.1154-0.04 = 425.86 The value per share can be estimated as the sum of the present value of FCFE during the high growth phase and the present value of the terminal value of equity: 45.97 + 425.86/ (1+0.1154)3 = 352.85p Book Value - Market Value Comparison Economic theory postulates that any difference between the market value of the firm and the accounting book value reflects the influence of future abnormal profits. When possible abnormal profits are anticipated the market value of the stock can be expected to to exceed the accounting book value and vice versa (Lev & Sougiannis, 1999). This happens because of the influence of intangible assets on the profitability of the firm, these assets such as brand image, market goodwill etc. may not be reduced to financial numbers. Nevertheless, they can have an influence on the future profitability of the firm. The present values for TESCO are: Book Value = 1.355 Market Value = 4.26 This represents a difference of the market value being over three times the book value. It is interesting to correlate this to the fact that TESCO has capitalised large amounts as accrued goodwill. This clearly indicates that the present price of the stock is very high in comparison with its book value and expectations of abnormal future profits. Conclusion: The stock is presently trading at 425.75 which then appears to be on the higher side as our analysis show and may be expected to go down. However, analysts are recommending a much higher EPS for the company at 24.9 and 28.06 (median estimates for 2008 and 20096) which do not agree with the estimates in the above valuation nor do the recommendations account for the cyclical performance of the EPS of the company as we have demonstrated. Therefore I do not agree with other reported analyst recommendations. My recommendation to a potential investor is - SELL Enclosure - 1 Operating Statement Comparison -TESCO Millions of GBP (Except per Share items) Year 2003 52 Weeks 2004 53 Weeks 2005 52 Weeks 2006 52 Weeks 2007 52 Weeks 2nd Qtr. 26 Weeks Details Revenue 26,004 30,814 33,866 39,454 42,641 22,631 Total Revenue 26,004 30,814 33,866 39,454 42,641 22,631 Cost of Revenue, Total 24444 28925 31231 36426 39401 21017 Selling & Admn Expenses 55 102 732 825 907 424 Unusual Expense (Income) 0 -223 Other Operat Expse, Total -49 -77 -92 -119 Total Operating Expense 24499 29027 31914 37174 39993 21322 Operating Income 1505 1787 1952 2280 2648 1309 Interest Income (Exp), Net Non-Operating -110 -126 -58 -45 5 -20 Gain (Loss) on Sale of Assets -13 -9 Depreciation/Amortization -21 -52 Net Income Before Taxes 1361 1600 1894 2235 2653 1289 Provision for Income Taxes 415 498 541 649 772 351 Net Income After Taxes 946 1102 1353 1586 1881 938 Minority Interest -2 -3 -6 -7 -2 Net Income Before Extra. Items 946 1100 1350 1580 1874 936 Total Extraordinary Items -6 -10 18 Net Income 946 1100 1344 1570 1892 936 Basic/Primary Weighted Average Shares 6989 7307 7707 7823 7936 7911 Basic EPS Excl. Extra. Items 0.135 0.151 0.175 0.202 0.236 0.118 Diluted Weighted Average Shares 7051 7368 7804 7932 8038 8032 Diluted EPS Excl. Extra. Items 0.134 0.149 0.173 0.199 0.233 0.117 Dividend Per Share 0.0600 0.0684 0.0756 0.0863 0.0964 0.0300 Dividend Payout - Common Stock 443 516 587 681 766 252 Interest Expense, Supplemental 289 230 235 174 138 104 Interest Capitalized, Supplemental -62 -62 -63 -67 -78 Depreciation, Supplemental 581 700 672 758 785 474 Total Special Items 34 61 -49 -77 -315 Normalized Income Before Tax 1395 1661 1845 2158 2338 1289 Effect of Special Items on Income Taxes 4 3 -14 -22 -92 Inc Tax Ex Impact of Sp Items 419 501 527 627 680 351 Normalized Income After Tax 976 1160 1318 1531 1658 938 Avail to Common (Excl Minority) 976 1158 1315 1525 1651 936 Basic Normalized EPS 13.965 15.848 17.062 19.494 20.804 11.832 Diluted Normalized EPS 13.842 15.717 16.850 19.226 20.540 11.653 Enclosure - 2 Balance Sheet Comparison - TESCO In Millions of GBP (Except per share items) As on February 287 2003 2004 2005 2006 2007 2007-08 Half Yr. ASSETS Cash 399 670 Cash & Equivalents 1146 1325 1042 1389 Short Term Investments 239 430 70 108 98 Cash and Short Term Investments 638 1100 1146 1395 1150 1487 Trade Accounts Receivable, Net 107 136 141 168 Other Receivables 507 585 665 783 Total Receivables, Net 614 826 721 806 951 1213 Inventory - Finished Goods 1122 1196 1306 1457 1911 Inventories - Other 18 3 3 7 20 Total Inventory 1140 1199 1309 1464 1931 2091 Prepaid Expenses 48 48 86 128 Discont. Ops.-Curr. Assets 168 408 13 Other Current Assets 8 6 Other Curr. Assets, Total 168 416 19 Total Current Assets 2440 3125 3224 3919 4576 4810 Land/Improvements 12493 13718 14247 15563 16540 Machinery/Equipment 4132 4479 4298 4707 5389 Property/Plant/Equipment - Gross 16625 18197 18545 20270 21929 Accumulated Depreciation -3797 -4103 -4024 -4388 -4953 Property/Plant/Equipment - Net 12828 14094 14521 15882 16976 18161 Goodwill, Gross 941 1058 1192 1235 1684 Accum. Goodwill Amort. -51 -93 -98 -98 -98 Goodwill, Net 890 965 1094 1137 1586 2141 Intangibles, Gross -- -- 596 694 855 Accum. Intangible Amort. -- -- -282 -306 -396 Intangibles, Net -- -- 314 388 459 LT Invt. - Affiliate Comp. 284 330 416 476 314 363 LT Investments - Other 59 6 572 749 864 930 Long Term Investments 343 336 988 1225 1178 1293 Def. Inc. Tax - LT Asset -- -- 14 12 32 28 Total Assets 16501 18520 20155 22563 24807 26433 LIABILITIES Accounts Payable 2198 2444 2848 2911 3445 6647 Accrued Expenses 433 510 884 909 1265 Notes Payable/Short Term Debt 1286 775 482 1646 1554 96 Curr. Port. LT Dbt/Cap Ls. 55 69 -- -- -- 1937 Dividends Payable 319 370 6 6 7 Income Taxes Payable 230 308 221 462 461 574 Other Payables 851 1040 1236 1257 1329 Discontinued Operations -- -- 0 86 0 -- Other Current Liabilities -- -- 3 241 91 4 Other Current Liabilities, Total 1400 1718 1466 2052 1888 578 Total Current Liabilities 5372 5516 5680 7518 8152 9258 Long Term Debt 3863 4180 4563 3742 4146 4588 Capital Lease Obligations 171 166 -- -- -- Total Long Term Debt 4034 4346 4563 3742 4146 4588 Total Debt 5375 5190 5045 5388 5700 6621 Deferred Income Tax 505 579 496 320 535 651 Minority Interest 43 45 51 64 65 59 Reserves 16 14 -- -- -- 26 Pension Benefits - Under-funded -- 735 1211 950 736 Other LT Liabilities 15 22 27 328 453 420 Other Liabilities, Total 31 36 762 1539 1403 1182 Total Liabilities 9985 10522 11552 13183 14301 15738 Equity Common Stock 362 384 389 395 397 394 Additional Paid-In Capital 2465 3470 3704 3988 4376 4425 Retained Earnings 3689 4144 4510 4997 5733 5876 Total Equity 6516 7998 8603 9380 10506 10695 Total Liabilities incl. Equity 16501 18520 20155 22563 24807 26433 Total Common Shares Outstanding 7238 7680 7783 7894 7947 7911 References: Campbell, J.Y., R.J. Shiller and M.P. Page, (1988): The dividend-price ratio and expectations of future dividends and discount factors. Review of Financial Studies Holmes, G. & Sugden, A. (1997): Interpreting Company Reports & Accounts, 6th edition, Prentice Hall Lev, B. and Sougiannis, T. (1996): The Capitalization, Amortization, and Value-relevance of R&D. Journal of Accounting & Economics, 21, p 107-138. Ohlson, J.A. (1995): Earnings, book values, and dividends in equity valuation, Contemporary Accounting Research Read More