Investment Analysis of Tesco, and Marks and Spencer - Research Paper Example

Investment Analysis of Tesco, and Marks And Spencer 1Introduction Today, millions of shares are traded on daily bases on the world's stock markets. (Penman, 2003). Investors who trade on these stocks are often ask themselves whether they are buying or selling at the right price. (Penman, 2003). In a quest of an answer to their investment decision, they often attempt to provide answers to these questions by turning to various media including investment analyst opinions in the printed press, financial networks etc in order to get a fare value of what they should pay for the shares. (Penman, 2003). In all the methods available to investors, investment analysts provide an almost endless stream of information and recommendations for investors to sort out. There are often claims that some shares are undervalued, some overvalued while the others value represent a true market value. (Penman, 2003). In other situation, investors make investment decisions following his or her instinct or based on the information provided by the market. Here, Penman (2003) referred to Investors who make investment decisions following their instinct as intuitive investors, while those who make investment decisions following market data are passive investors (Penman, 2003). This study is aimed at carrying out a comparative analysis of two United Kingdom based retail companies with particular focus on its financial performance and share valuation for the two periods under review, to enable the researcher gain a reasonable basis for providing recommendations to investors on which company's stock they should buy, sell, keep or hold. The remaining part of the paper looks at the two company under review. 2.0 Analysis of the UK Retail Industry Like macroeconomic analysis the analysis of the industry is important because it enables the analysts to make abnormal profits arising from information asymmetry between the proper analyst and competitors who fail to carry out a proper analysis. Just as it is difficult for a firm to do well in a poor macroeconomic environment, so too is it difficult for a firm to perform well in a troubled industry. (Bodie et al, 2002). Similarly, as performance can vary across countries, so too does it varies across industries. (Bodie et al, 2002). 2.1 Tesco Plc Tesco PLC is an international retailer. The principal activity of the Company is food retailing with over 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. It activities include, simple travel insurance, Tesco personal finance, telecom and retail outlets. 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 quite well. In 2006 for example the was an improvements in all the profitability ratios when compared to 2005. Compared with the ratios for the other firm (Mark & Spencer) we see that Tesco performed better than the industry average, and better than M&S. However, Marks and Spencer also proves to be a profitable company. b) Liquidity Ratios for Tesco Plc Ratio Formula2 2006 2005 Current Ratio Quick Ratio Cash Ratio Tesco current ratios have also witnessed improvements in 2006. The current ratio and quick ratio show that Tesco 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 than its M&S. c) ) 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-to-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 We 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 as at 2006, which implies that the value per share is given by 52,902,250/7,229508 = 7.3175 = 731.75p. The current share price was 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. 2.2 Mark & Spencer Marks and Spencer Group plc is the holding company of the Marks & Spencer group of companies. The Company is a retailer of clothing, food and home products. The Company trades in wholly owned stores in the Republic of Ireland and Hong Kong, as well as in worldwide franchise stores. It had 144 Simply Food stores across the United Kingdom. International business comprises wholly owned stores, in the Republic of Ireland and Hong Kong, and 198 M&S branded franchise stores worldwide, including 22 stores opened during the fiscal year ended April 1, 2006. On April 28, 2006, the Company completed the sale of Kings Super Markets, its wholly owned supermarket chain in the United States. (http://finance.google.com/financeq=LON%3AMKS) Financial Ratio Analysis for Marks and Spencer Group Plc a) Profitability Ratios for M&S Ratio Formula 2006 2005 Profit margin Return on Capital Employed Return on Equity Return on Investment The company proves to be the most profitable earning a return on equity of 45% in 2006. One can also observe improvements in the figures from 2005 except the figure for return on investment which witnessed a decrease from 12% in 2005 to 10% in 2006. However, the company is more profitable than Tesco under study. b) Liquidity Ratios for Marks and Spencer Plc Ratio Formula 2006 2005 Current Ratio Quick Ratio Cash Ratio The liquidity ratios show that the operating leverage is very high. This is because is current liabilities outweigh current liabilities. Its cash flows from operations might therefore be unable to cover current liabilities. The company is therefore facing business risk. c) ) Long-Term Solvency Ratios Looking at the long-term solvency ratios, the company shows that it is a high gearing company with a debt-to-equity ratio of 3.5%, it therefore runs the risk of not meeting its interest and principal repayments with ease which might ultimately lead it to financial distress. Valuation of Marks and Spencer Group Plc. Profit for the year 2006 = 523.1 Dividends paid = 204.1 Pay out ratio = 204.1/523.1 = 0.39 Retention ration = 1- 0.39 = 0.61 ROE = 45% Growth rate in dividends = ROE x retention rate. g = 45 x 0.61= 27.45%. Dividends in 2007 should therefore be given by 204.1(1.274) = 260.02 Dividend yield = dividends in 2007/price in 2006 The price of the stock in 2006 was 250p. The earnings per share was 31.3p for a total earnings of 523.1million Therefore the number of shares outstanding is given by 52,310,000/0.313 = 1,671,246,006 Therefore the price in 2006 was 0.25 x 1,671,246,006= 41,781,150.15 Therefore r = 260,020,000/417,811,501.5+ 27.4% = 89,6% The figure calculated here for the capitalisation rate appears to be unrealistic. No company can borrow at this rate. We therefore assume that given the leverage of Marks and Spencer, it faces more risk and instead of using a cost of capital of 13.7% we will use 15%. To value its operations, we apply the dividend growth model stated earlier in equation 2. = 200015385+196017640+192097287+188255341+7280268491 = 8,056,654,144 There are 1,671,246,006 shares outstanding. This implies that the price per share is given by 8,056,654,144/1,671,246,006 = 48.17 = 4817p. The market value of the stock today is 329.25p. However, the value calculated here is by far greater than the value in the market. Therefore we recommend a hold and buy decision. 3.0 Conclusion This study carried out an analysis of two companies in the retail industry in the United Kingdom. In the course of the study, the two companies were found to be very profitable Tesco and Marks and Spencer. The valuation analysis also proves that Tesco and Marks and Spencer are undervalued. For example, as at 2006, there were 7,229508 outstanding shares in Tesco, which implies that the value per share was given by 52,902,250/7, 229508 = 7.3175 = 731.75p. The current share price as calculated by then was 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. Its 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. For M&S there were 1,671,246,006 shares outstanding. This implies that the price per share then was given by 8,056,654,144/1,671,246,006 = 48.17 = 4817p. The market value of the stock today is 329.25p. However, the value calculated here is by far greater than the value in the market. Therefore, we recommend a hold and buy decision for the shares. However, since the study requires that only one of the shares should be recommended for investment, we recommend a hold and buy decision for the shares of Mark and Spencer, since the value calculated is by far greater than the value in the market. References Bodie Z. Kane A., Marcus A. J. (2002). Investments. 5th Ediction. McGraw-Hill Penman S. H. (2003). Financial Statement Analysis and Securities Valuation. Second International Edition. McGraw-Hill Read More