Business valuation of Tesco

Table of Contents:

A) Introduction

B) Methods
1. Net Asset Value
2. Price-Earnings Ratio
3. Discounted Cash Flow
4. Dividend Valuation Model
5. Economic Value Added

C) Comparison

D) CAPM

E) Appendix
1. CAPM calculations
2. WACC calculations
3. Market capitalisation
4. NAV calculations
5. DCF calculations
6. DVM calculations
7. EVA calculations

F) References

G) Bibliography

A) Introduction

Below you will find a financial report about Tesco.plc which is quoted on the London Stock Exchange (TSCO.L). Firstly, the company is valued on the basis of five different approaches (NAV, PER, DCF, DVM, EVA) and secondly, the different approaches are compared to detect distinctions. Maximising shareholder value is the superior aim in this context but what about claims of stakeholders like workforce for example?

Tesco is one of the world`s biggest retailers with over 2,700 stores worldwide. The core business is food retailing but Tesco has diversified its assortment in recent years into the non-food sector, banking, insurance and telecommunications.¹

Tesco had a market capitalisation of 33,144.63 million pounds and 7,919.863 million issued shares on 14.01.2007.²

This coursework underlies the limitation of limited data input. Within the coursework it is not possible to forecast future based figures like growth rates for example as detailed as possible, therefore results can have big variations. Nobody is able to predict the future, but more detailed input figures will achieve better results.

B) Methods

1) Net Asset Value Method (NAV)

The NAV approach is based on the company`s balance sheet and deduces the company value from the accounting equation:

Equity = Assets – Liabilities (source: lecture notes)

Tesco`s NAV deducted from the 2006 balance sheet is 9,444 million pounds.

(Detailed calculations of the NAV can be seen in E3 of the appendix)

Advantages:

NAV has the advantage that the required data is easy available from the balance sheet and the calculation itself is easy, too. It makes sense to use NAV for the shareholders when the company has financial problems. In times of financial need it is important to know what the asset are worth to evaluate what will happen with regard to borrowing, asset sales or break-up value. In situations of takeover bids shareholders will not sell under NAV because otherwise they would sell the assets under book value.³

Disadvantages:

All data used for the NAV calculation comes from the company`s balance sheet what means that the NAV is historic driven and faces the problems coming along with accounting standards. For example, fixed asset figures from the balance sheet do not reflect the real market prices of fixed assets often because firms can depreciate high amounts of the assets that do not fit to real obsolescence of the assets. Hence, fixed assets are often out of date. “Stock values are often unreliable” and “the debtors figure may also be suspect.” (lecture notes) The NAV approach regards the value of a company as the value of the net assets alone and does not consider future performance or workforce what is important for investors.⁴

2) Price-Earnings Ratio (PER)

The PER is the market price of a share divided by the last reported earnings per share:

Historic PER: Current market price of share

Last year`s earnings per share (source: Arnold, 2006, p. 922)⁵

A high PER is an indicator for positive future expectations of share purchasers.

PER 2002 – 2006:

illustration not visible in this excerpt

(source: Tesco`s annual reports and Yahoo.finance)⁶⁷

Abbildung in dieser Leseprobe nicht enthalten

Advantages:

PER is a widely used tool for investors to compare share values. It is easy comparable with PERs of other companies or sectors in order to detect disparities. The PER is an indicator for the future expectations of share purchasers.

Disadvantages:

It is difficult to define what a normal PER is, you can compare the different PERs and the relatively difference may be right but maybe all shares in a special industry are overvalued because of a bubble at the stock exchange for a certain industry (e.g. new economy). It only provides relative figures and allows no absolute measurement. Furthermore, it is difficult to value companies with no or negative income. Although, these companies are expected to do well in the future you can not get a useful PER because of the negative income. The model does not “provide a framework for the analyst to test the important implicit input assumptions” (Arnold, 2005, p. 923)⁸ like different growth rates in earnings or different risk levels in the form of different required rates of return. The PER varies with the share price, but it also derives from it, so is it helpful regarding company valuation?

B3) Discounted Cash Flow Model (DCF)

The DCF approach calculates the present value of the firm by discounting its forecasted future cash flows.

n

Vo = ∑ Ct / (1+ke)t

t=0

(source: lecture notes)

The present value of Tesco`s discounted cash flows is 62,883.772 million pounds.

(Detailed calculations of the NAV can be seen in E4 of the appendix!)

Advantages

The DCF model calculates the value of the company from its future cash flows what is rather rational than using accounting earnings because of accounting conventions. Ultimately, the provided cash flow is what an investor is interested in. “DCF analysis can help investors identify where the company's value is coming from and whether or not its current share price is justified.” (Ben McClure, 2006, Investopedia)⁹

Disadvantages

The approach is based on some uncertain assumptions and is only as good as its input factors. Predicting cash flows a few years into the future is hard enough but predicting the needed perpetuity growth rate is nearly impossible. The model requires an appropriate discount rate but to find one could be difficult, in this case CAPM has been used but the model has its own difficulties, too. (q.v. CAPM) Small changes in assumptions can have big impacts. “Following the "garbage in, garbage out" principle, if the inputs into the model are "garbage", then the output will be similar.” (Ben McClure, 2006, Investopedia)¹⁰

[...]

¹ Tesco (2006), Homepage – Investor Centre, Tesco, available from http://www.tescocorporate.com/page.aspx?pointerid=FC28BF669D98474CAA7B6312D6C225B3

[accessed 10 December 2006]

² Tesco (2006), Homepage – Investor Centre, Tesco, available from http://www.tescocorporate.com/page.aspx?pointerid=FC28BF669D98474CAA7B6312D6C225B3

[accessed 10 December 2006]

³ Arnold, Glen (2005), Corporate Financial Management, Third edition, Harlow: Pearson Educated Limited

⁴ Arnold, Glen (2005), Corporate Financial Management, Third edition, Harlow: Pearson Educated Limited

⁵ Arnold, Glen (2005), Corporate Financial Management, Third edition, Harlow: Pearson Educated Limited

⁶ Tesco (2006), Homepage – Investor Centre, Tesco, available from http://www.tescocorporate.com/page.aspx?pointerid=FC28BF669D98474CAA7B6312D6C225B3

[accessed 10 December 2006]

⁷ Yahoo.finance (2007), Homepage, Yahoo, available from http://finance.yahoo.com/

[accessed 2 January 2007]

⁸ Arnold, Glen (2005), Corporate Financial Management, Third edition, Harlow: Pearson Educated Limited

⁹ McClure, Ben (2006), Homepage - DCF Analysis: Pros & Cons Of DCF, Investopedia, available from http://www.investopedia.com/university/dcf/dcf5.asp [accessed 27 December 2006]

¹⁰ McClure, Ben (2006), Homepage - DCF Analysis: Pros & Cons Of DCF, Investopedia, available from http://www.investopedia.com/university/dcf/dcf5.asp [accessed 27 December 2006]