Investment Analysis and Valuation of Tesco Plc - Essay Example

 Investment Analysis and Valuation of Tesco Plc 1. Introduction. Globalisation, the new information technology, and deregulation of financial markets and the quest for market dominance have eased the provision and search of finance. Today, millions of shares are traded every day on the world’s stock markets. (Penman, 2003). Most often, investors see valuation as the first step toward intelligent investing. It has been argued (e.g. Penman 2003) that an investor can make informed decisions about where to invest once the value of shares are determine based upon the fundamentals. This is so because, without this value investors can either buy high or sell low Investors who trade on these stocks are often forced to ask themselves whether they are buying or selling at the right price. (Penman, 2003). In the face of this situation and their quest for an alternate answer, investors turn to various media including internet chat rooms, printed press, “talking heads” on television and financial networks, who often voice opinions on what they feel the stock prices should be. (Penman, 2003). In addition, investors consult investment analysts who provide an almost endless stream of information and recommendations to sort out. There are often claims that some shares are undervalued and vice versa. (Penman, 2003). Faced with too much information, Investors at times get confused with no clear indication of what the true prices of stocks should be. (Penman, 2003). Under such circumstances, the investor either make decision based on his or her instinct, such investors according to Penman (2003) are intuitive investors while others who make their decision based on capital market efficiency are referred to as passive investors. Penman, (2003) further argues that in making their decision, passive investors assumed that the market price is a fair price of the shares quoted. These investment mechanisms appear to be very simple, as they do not require much effort. (Penman, 2003: pp 3). How ever that is not the case as neither passive nor intuitive investor turn to be better off in the face of their decision. This is so because these sets of investors can either pay to high or sell too low. Having said that, in the sections that follow, I will discuss analysis and valuation of Tesco Plc including its products, customers, employees, management, and corporate governance. I have also highlighted in a passing the methodology used in valuating the company. In the last section, I will make a conclusion and recommendation to prospective investors. Tesco Plc Tesco Plc is one of the market leader and a global player in the retail industry. The main activities of the company include food retailing, insurance, banking and other services. Tesco has about 2,000 stores in the United Kingdom, the Republic of Ireland, Hungary, Poland, the Czech Republic, Slovakia, Turkey, Thailand, South Korea, Taiwan, Malaysia, Japan and China. On September 30, 2005, the Company entered into an agreement to dispose of its operation in Taiwan to Carrefour as part of a transaction to acquire Carrefour's businesses in the Czech Republic and Slovakia. On July 17, 2006, the Company acquired Leader Price in Poland. In December 2006, the Company acquired the Macro business in Malaysia. The eight stores purchased in the transaction comprise over 800,000 square feet of sales area. Distribution Channels Tesco operates 165 International Express stores. In addition it operates 39 stores in China, 111 in Japan, 13 in Malaysia, 62 in South Korea, 6 in Taiwan, 219 in Thailand, 35 in Czech Republic, 87 in Hungary, 105 in Poland, 91 in Republic of Ireland, 37 in Slovakia and 8 in Turkey. It operates a total of 1898 stores in the United Kingdom. Tesco operates 24 hours a day and seven days a week. (Tesco Annual Review, 2006). It therefore operates round the clock which demonstrates its commitment to create customer value which will in turn generate superior value for its shareholders. With over a decade of international experience, the company has developed a strategy that has given it the confidence to grow its existing businesses and invest in new markets. In those countries which formed the first part of Tesco’s international expansion in the late 1990s, such as Thailand and Hungary, Tesco now has substantial, successful, local businesses, which help it to develop the blueprint for new markets, such as its Hymall joint venture in China. Tesco also distributes its products and services online through its website www.tesco.com. For example, 97% of the UK customers have access to its website www.tesco.com. Employees One of our core values is to treat people how we like to be treated. It is important to us that Tesco is a great place to work and that our staff are given the training and opportunity to get on. We have training schemes for every career stage and more than 80% of our management roles are filled internally. Over 7,000 members of staff are on a development programme designed to give them the skills and experience to move to a bigger job. We invested in over 2,000 new management and 4,500 Team Leader roles at the checkouts last year to continue to deliver Every Little Helps for customers. Services Simple Travel Insurance Tesco has over five million active customer accounts, including 1.8 million credit card holders. Its customers love the simplicity of its financial services. For example, travel insurance. If you’re a Clubcard holder then all you need to do is pick up a pack in-store and take it to the checkout with the rest of your shopping. As soon as the insurance pack is scanned along with your Clubcard, you are insured for your trip. Tesco Personal Finance Tesco now offers 21 financial products and services from loans and savings accounts to credit cards and insurance. It is the UK’s third largest online car insurer with over 1.4 million active car insurance policies. It is continuously trying to improve its offer for customers and now offers the opportunity to purchase travel money in-store, by providing kiosks in seven stores. To date, over 70,000 customers have used this service. It has also made the purchase of premium bonds much more convenient for customers. The partnership with National Savings & Investments (NS&I) and Tesco Personal Finance enables customers to pick up brochures for NS&I tax-free premium bonds, and its range of inflation-beating index-linked savings certificates, alongside their weekly shop. TELECOMS In the run up to Christmas 2005, Tesco was the third largest pay-as-you-go mobile retailer. We offer our customers a comprehensive range of landline phones, telecoms accessories, pay-as-you-go mobile phones and airtime. In December 2005, it launched its first dedicated telecoms centre in our Slough store. Corporate responsibility Culture Centres This year, we opened six new Culture Centres in our stores in South Korea, which offer 300 different sorts of educational and cultural programmes including dancing, karate and cookery lessons. We now have 37 of these centres with 350,000 members and 2,300 instructors. We raised 114 million KRW through various events, including a charity bazaar and staff fundraising, and we donated 50,000 products worth 350 million KRW to various charities. Recycling with its customers This is an area that Tesco has invested in to make recycling easier and more attractive. In 2005 it invested over £600,000 in new automated recycling machines for customers at its stores in Winchester, Havant, Portsmouth, Southampton, Andover and Royston and it plans to install these at many more stores. It believes this will enable it to double the amount its customers bring for recycling and this additional material would account for around 10% of the total additional tonnage needed to meet the UK’s EU packaging recycling targets by 2008. Financial Ratio Analysis for Tesco Plc. a) Profitability Ratios for Tesco Plc Ratio Formula1 2006 2005 Profit margin Return on Capital Employed Return on Equity Return on Investment The profitability ratios show that the company is doing well and there have been improvements from 2005 in almost all the ratios. b) Liquidity Ratios for Tesco Plc Ratio Formula2 2006 2005 Current Ratio Quick Ratio Cash Ratio The current ratios have also witnessed improvements from 2005. the current ratio and quick ratio show that Tesco is has enough current assets to cover its short-term liabilities without facing business risk, that is the risk that it might not meet its short-term commitments. However, the cash ratio shows that Tesco could only cover 50% of its short-term liabilities in 2005 and 90% in 2006. It is again doing better in this domain. Long-Term Solvency Ratios Solvency Stock Measures From above, it can be observed that the company uses more debt than equity in financing its activities. This is evidenced by the debt-t-equity ratio of 1.4. There is therefore some minimal effects of financial risk. That is, the risk that the firm might not meet its long-term debt obligations. Valuation of Tesco Plc. Methodology I will value to firm using two methods, which include the dividend growth model and the Cash flow valuation model. Dividend Growth Model The constant growth dividend model can be written as follows: , ........................(1) (Bodie et al, 2002) Where: is the intrinsic value of the firm at time 0 is the current dividend on the stock at time 0. g is the growth rate in dividends r is the capitalisation rate. If we assume that we want to value the firm say for the next 5 years from 2006 to 2011, then we can write the current value of the firm thus where is the forecasted price at which the stock can sell at the year 2012. We know that r =(Bodie et al, 2002) Where is the dividend yield on the stock. Therefore for Tesco r = g = ROE x retention ratio. = ROE x (1-dividend payout ratio) (Bodie et al, 2002: pp 575). Tesco Plc according to its 2006 annual report made a profit of £1,570,000 and paid dividends of £441,000. This represents a payout ratio of 441/1,570 = 0.28. The ROE that we calculated earlier for 2006 was 16.7%. Therefore the growth in dividends is given by g = 16.7(1-0.28) = 12.0% = = 441(1.12) = 493,92 the company’s share price on 1st December 2006 was 392.75p per share for 7,229508 shares outstanding which amounts to a total price of £28393893.44 Therefore from the above information we can calculate the capitalisation rate as follows: r = 493,920/28393893.44+ 0.12 = 13.7%. the price at 2012 when dividends enter their constant growth phase is given by = 441,000(1.12)5(1.12)/(0.137-0.12) = £51,203,282.6 We can now substitute the above inputs into equation 2 to get the value for Tesco as at 2006. = 434406.3 + 427910.9 + 421531.1 + 415210.9 + = 52,902,250. There are 7,229508 outstanding, which implies that the value per share is given by 52,902,250/7,229508 = 7.3175 = 731.75p. The current share price is 473.75p while the value calculated here is 731.75p. This means that the stock is undervalued; it is therefore consistent with a buy or hold decision. In addition, the company is earning above its cost of equity capital. It’s return on equity (ROE) is 16.7% while its cost of capital is 13.7% the company therefore earns a return of 3% above its equity cost of capital. This provides further evidence of a buy or hold decision. Residual earnings Model The residual earnings model is a model that anchors the valuation of equity on the book value of equity. The residual earnings valuation model can be written as follows: (2) Where RE is the residual earnings B0 is the book value at the beginning of the period, is the value of equity at time zero and is equal to 1 plus the cost of equity capital estimated using the capital asset pricing model. Residual earnings represent the residual earnings for equity and it is given by comprehensive earnings less (required return x beginning book value of equity). This can be written mathematically as follows: (3) (Penman, 2003: p. 145). We therefore calculate the value of equity by adding the present value of forecasted residual earnings to the current book value of equity in the balance sheet. The forecasted residual earnings are discounted to present value by 1 plus the equity cost of capital. The intrinsic premium over book value is therefore the difference between value of equity calculated using the residual earnings model less the book value of equity reported in the balance sheet. The premium is in effect the missing value in the balance sheet. The price to book ratio can be determined from equation 2 as follows: (4) (Penman, 2003: p. 145). The implication of equation 4 is that if investors expect the firm to earn income over the require rate of return, or the cost of equity capital (that is positive RE), its equity will be worth more than its book value and should therefore sell at a premium over book value. (Penman, 2003: p. 145). The model in equation 2 implies that we are valuing the firm to infinity. However, it is necessary to specify an explicit forecast horizon for the residual earnings say 5 years. Consequently we need to calculate a continuing value at the end of the 5th year since the company is a going concern. (Penman, 2003). Taking this into consideration, we can now calculate the value of equity from the following model: (5) We now have our model in place and ready to apply it to value Tesco Plc’s equity. We begin by calculating the equity cost of capital for Tesco. This can be done using the CAPM expressed in equation 1 above. Financial Times Ltd (2007) reports a beta for Tesco of 0.65 and a market return on the FTSE100 index of 13.4. Also according to the BBC (2007) prevailing interest rates in the UK now stand at 5.57%. Applying these inputs to equation (1) the cost of capital can estimated as follows: = 0.10445 = 10.4%. The book value of the company in 2005 was £3,050,721 and the earnings in 2006 were £149,420. Consequently the residual earnings can be calculated as follows: RE2006 = 149,420 – 0.104*3,050,721 = £-38282.3. Tesco Plc has a total of 2.44million shares outstanding, therefore the residual earnings per share is £-0.01569 (£-38282.3./2.44million) 1.4 Conclusion From the above valuation, one will not hesitate to say that Tesco shares are currently undervalue. The company is doing well in the market especially when compared to some of its peer group. This conclusion is drawn based on its profitability ratio and information gotten from the valuation References Bodie Z. Kane A., Marcus A. J. (2005). Investments. 6th Edition. McGraw-Hill Myers S. C. Brealey R. A. (2002). Principles of Corporate Finance. Seventh Edition McGraw-Hill. Penman S. (2003). Financial Statement Analysis and Security Valuation. Second Edition. McGraw-Hill. Ross S.A., Westerfield R.W., Jaffe J. (1999). Corporate Finance. Fifth Edition. McGraw-Hill International Ediction Finance Series. www.googlefinance .com Tesco www.tesco.com APPENDIX Read More