Company valuation

1 Introduction – Organization Selected

In this assignment, we will conduct the valuation of Tesco Plc by adopting appropriate valuation techniques.  Tesco Plc, incorporated in United Kingdom is the largest food retailer in that country.  It is also a key international player, holding over 900 stores in ten different countries (Institute for Transportation and Development Policy).

Prior the year 2000, Tesco Plc operated stores in Chez Republic, France, Hungary, Republic of Ireland, Poland, Slovakia, South Korea and Thailand, apart from the United Kingdom.  From 2000 onwards, stores in Turkey, Taiwan, Malaysia Japan and China were also set.  Tesco Plc is listed on the FTSE 100 of the United Kingdom Stock Exchange.  It also has a secondary listing on the Irish Stock Exchange under the name of the parent company Tesco Plc (Answers.com).

1.1  Enhancement of the Shareholders Value in the last 5 Years

The value of shareholders is affected by a number of factors, which are controllable or uncontrollable by the organization.  It is important that we comprehend such factors before we evaluate the success of Tesco Plc in this respect.  The most common value drives of a company are:

·         Profitability and sales growth of the organization.

·         Working capital management and investment in fixed capital.

·         Balance in the cost of capital of the company through an appropriate capital structure.

·         The tax rate affects on shareholders returns.

The first three points are within the corporations control and should be taken into account in this section.  However, the latter point is affected by the government and thus has no relevance in the proceeding discussion.

Key variables that portray the aforementioned value drives for the last five financial years of Tesco Plc as shown in the following table:

Financial Indicators 2006 2005 2004 2003 2002 Diluted earnings per share 19.92p 17.30p 14.93p 13.42p 11.86p Basic earnings per share 20.20p 17.52p 15.05p 13.54p 12.05p Dividend per share 8.63p 7.56p 6.84p 6.20p 5.60p Return on capital employed 12.7% 11.8% 10.4% 10.2% 10.8% Gearing 60% 68% 55% 62% 50% Source: Tescocorporate.com

An improving return on capital employed show that one of the key strengths of the corporation is profitability and efficiency.  Management was more efficient in the adoption of the firm’s resources to generate profits as revealed by the 1.9% increase in the return on capital employed over the past five years.  This stemmed from the fact that higher sales revenue were derived from resource utilized together with further enhanced control on operating costs (Randall H. 1999, p 466, 467).  This positive element will enhance the equity value of the company.

The investors are gaining from this high profitability as indicated by the rising diluted and basic earnings per share and dividend per share.  The earnings per share, for instance shows that the earnings attained by the shareholders on the basis of every 1 share held in the corporation.  In fact, the significantly high price/earnings ratio determined and examined in sub-section 1.3.2 and section 1.4, is the result of the increasing return on investment stemming from the rising profitability and efficiency in Tesco Plc (Randall H. 1999, p 471).

The organisation is presently a high-geared company as shown by the gearing ratio.  Gearing is a capital structure ratio that shows the proportion of equity to debt finance.  The higher the gearing ratio, the greater the firm’s dependence on long term borrowings and thus the greater the risk the corporation being financially unstable (Randall H. 1999, p 470-471).  From a neutral geared company in 2002, Tesco Plc ended up a high geared company.  Presently, this is the only factor against the organization’s value.

1.2 Equity Value in the last 12 months

The market to book ratio of Tesco Plc is improving in line with the positive factors of noted in the previous section.

The 9% rise in the total equity portrayed in the balance sheet of 2006 stemming from an issue of share capital and an 11% increase in retained profits is also sustaining a sound equity value.

1.3 Valuation of Tesco Plc

During the years, different schools of thought have evolved in Financial Management leading to different valuation methods of a company.  In this section, we will apply three basic valuation models to the evaluation of Tesco Plc, which comprise the Net Asset Value Approach, Price-Earnings Multiples Tool and Discounted Cash Flow Technique.

1.3.1 Net Asset Value Approach

This is a simple method that utilizes the published accounts prepared and presented by each limited company at the end of the financial year.  The Financial Statements prepared by Tesco Plc for the financial year ended 2006, portrayed on Tesco Plc main website reveal the main items of the net asset value, which are the non-current assets, current assets, current liabilities and non-current liabilities.  The net asset value of 2006 and 2005 are computed below:

Details 2006

£’ millions Non-current assets 18,644 Current assets 3,919 Total Assets 22,563 Less: Liabilities: Non-current liabilities 5,601 Current liabilities 7,518 Total Liabilities 13,119 Net assets of Tesco Plc as at 25th February 2006 9,444 Details 2005

£’ millions Non-current assets 16,931 Current assets 3,224 Total Assets 20,155 Less: Liabilities: Non-current liabilities 5,821 Current liabilities 5,680 Total Liabilities 11,501 Net assets of Tesco Plc as at 25th February 2005 8,654 1.3.2 Price Earnings Multiples Tool

Before computing the price earnings ratio, it is important that we comprehend the meaning of such measurement.  The price earnings ratio shows the value of stock in the capital market, in line with increasing return on investment (Randall H. 1999, p 471).  Therefore the higher the profitability of the company, the greater the confidence of the market and the higher the price earnings ratio.  In this respect, we are expecting a rise in the price earnings ratio, portraying an enhancement in the company’s value in light of the high profitability as indicated by the dividend cover, dividend yield and return on equity, in section 1.1.

The Price Earnings Ratio of Tesco Plc is determined by utilizing the following investor’s formula:

The answer derived from the aforementioned formula is in pounds per share.  We can translate it in whole figures to enable comparability and distinction with the other company valuation techniques by multiply it with the number of shares outstanding at that particular date.  This is calculated below:

2006: 19.65 x £10,700 million = £210,255 million

2005: 18.93 x £10,600 million = £200,658 million

Source: Tesco Plc (2006), note 24, p 84.

1.3.3 Discounted Cash Flow Technique

This model values a company from the perspective of cash flow.  Indeed the free cash flow is an important variable in the equation, which is shown below.  Free cash flow comprises the cash and cash equivalents from operating activities, in which cash and cash equivalents derived from investing operations, are not considered.  The equation utilized in order to evaluate Tesco Plc is the following:

Source:  Pike R. et al 1999, p 104.

Where: VO = Valuation of company under free cash flow technique.

            FCF = Free Cash Flow

            Ke = Cost of equity capital

            t = Valuation of cost of equity capital at a particular period.

As we can see in order to ascertain the value of Tesco Plc at a particular year, we ought to determine the cost of equity capital, which is an important variable in the formula provided above.

The Capital Asset Pricing Model is a technique, which is frequently used to determine the cost of equity, even though it is based on assumptions that are not applicable in the market.  For example, it is presumed that there is no transaction costs entailed in trading securities (Pike R. et al 1999, p 294).  The formula that will be adopted in order to measure the cost of equity capital for Tesco Plc at 2006 and 2005 is portrayed below:

Ke = Rf + β(ERm – Rf)

Where: Ke = Cost of equity capital

            Rf = Risk free rate of return

            β = Beta coefficient (systematic risk)

            ERm = Rate of return of the appropriate asset class.

By applying the above formula to the 2006 figures, the cost of equity would amount to the following:

Ke = 4.5% + 0.64(9.5% - 4.5%)

Ke = 7.7%

For 2005, the cost of equity comprised the following amount:

Ke = 4.5% + 0.98(9.5% - 4.5%)

Ke = 9.4%

Source: Reuters.com

Now the valuation of the company on 2006 and 2005 can be ascertained by utilizing the aforesaid formula and apply the discount rate determined.  This is portrayed below:

Value of Tesco Plc on 2006:

Value of Tesco Plc on 2005:

Source: Tesco Plc 2006, p 45.

1.4 Reconciliation of Differences between the Valuation Methods

It is frequently contended in financial management that the company valuation techniques normally adopted provide values that substantially differ.  Indeed as one can see in the table below, the valuation of Tesco Plc under these methods shows material discrepancies between each.

Tesco Plc Valuation Method 2006

£ millions 2005

£ millions Net Asset Value Approach 9,444 8,654 Price Earnings Multiple Tool 210,255 200,658 Discounted Cash Flow Technique 2,448 1,989 The differences arising from the methods stem from different perspectives that the models adopt.   The net asset value approach evaluates the organization from a balance sheet perspective.  The problems in this valuation technique stem from the accounting issues that a balance sheet holds.  Critics of such system state that measurement of fixed assets at historical cost basis and the deduction of depreciation over the useful life of the asset is inherently deficient.  This is due to the fact that the value of non-current assets shown in the balance sheet will rarely represent the market value of such resources.

Historical measurement basis proponents defend on such criticism by stating that corporations periodically review the value of tangible fixed assets, namely freehold land and buildings in order to reflect the market value of theses assets in the financial statements.  However in practice a limited number of organizations adopt such evaluations in practice due to the high administrative costs that they normally entail (Pike R. et al 1999, p 94 to 99).

It is also contended that stock and debtors valuation is intrinsically fallacious in the accounts.  The excessive prudence adopted by valuing stock at the lower of cost or net realizable value lead to underestimation of stock items.  This mainly applies to commodities than recurrently increase in price like fuel.  Arguments can also be applied on the inaccuracy of the trade receivables figure under which dubious debtors figures are included in the balance sheet leading to an overstatement of this current asset (Pike R. et al 1999, p 95 to 96).

Another element, which is omitted from the balance sheet and sustains the notion that this method is inaccurate and leads to understatement of the value of the company is the inclusion of intangible assets.  For instance the reputation gained by the company from providing good products and associated services is not considered in the balance sheet.  The inclusion of such elements will improve the net asset value of the firm.

Executive management in organizations has shown their concern on such issue due to the favorable effect that it will pose on the share price in the capital market.  However, under strong-forms of capital markets this will pose no influence since the market would be already knowledgeable of this economic brand value (Pike R. et al 1999, p 97).

The utility of the net asset value technique is seriously hindered due to past business combinations, which revealed that the value of the company portrayed in the purchase consideration was much higher than the net asset value.  For example, the acquisition in 1988 of the United Kingdom chocolate producer Rowntree by Nestle or the Swiss Confectionery showed that the company valuation offered by these firms was much higher than the net assets valued computed in the financial statements of the company (Pike R. et al 1999, p 97).  In fact, due to such limitations the role of the net asset value model is limited only to set a guide for the lower limit of the organization’s value of equity (Pike R. et al 1999, p 99).

The increase in the value of Tesco Plc of £790 million under the net asset value approach stems from the increase in the net assets.  This differs from the increase in equity value of Tesco Plc through the price earnings multiple model, which shows an increase of £9,597 million.  Such discrepancy is due to the approach taken by the model.  The price earnings multiple tool values the company from the income perspective rather than the net asset value.  Therefore the value of the company will be subject to the profits made by the corporation.

In accounting, the capital expenditure entailed in the purchase of non-current assets does not affect the income of the company.  The profitability of the firm will be influenced by the economic benefits that such tangible investments will provide to the business enterprise.  These will probably be higher than such capital cost in order to aid an increase in revenue.

Therefore if an organization is facing an increase in net assets and a rise in profits, like Tesco Plc, then the value of the company under the price earnings multiple method will be much higher than the net asset value approach due to the greater economic profit attained.

Empirical evidence suggests that the price earnings multiple technique is the most popular method that is used in practice to appraise companies.  The main advantage of this valuation model is that it aids investors in detecting over-valuations or under-valuations of companies arising from slow inefficient capital markets (Pike R. et al 1999, p 100).

However, the price earnings ratio should be considered carefully by financial analysts and investors because it may mislead investors that are evaluating the company to buy equity in.  Corporations with a fallen or rising stock price may be influenced from directors who are purchasing or disposing of their shares in such organization (Kennon J.)

In addition, the truth and fairness of the profitability figure, which highly affects the price earnings ratio, should be considered meticulously.  It is not the first time that profit figures are inflated through changes in accounting policies or new accounting measurement basis with the intention of fooling the market.  The classical example that comes to mind is the Enron incident.  Through the fair value accounting model applied by the aforesaid organization, this corporation was able to portray unrealistic profit figures and mislead the capital market for a considerable time.

The net asset value approach, price earnings multiple model and the discounted cash flow technique again differ from the perspective taken.  In the latter model, a cash flow approach is taken.  This significantly differs from the net asset value method like the price earnings system.  However, the price earnings multiple tool is different from the cash flow technique because the profit generated by the company is different than the free cash flow attained by the organization.  Under profitability non cash expenditure like depreciation are deducted from the profit, which are not considered in the cash flow computation.

The expenditure and revenue is also accounted for when incurred in the income statement and not when paid.  Thus discrepancies will arise between these two figures due to such different calculations leading to a different value of the company.  Indeed under the price earnings multiple tool a rise in Tesco Plc value of £9,597 million was noted, while an increase of £459 million arose in the discounted cash flow technique.

The limitations of the discounted cash flow method are similar to those of the price earnings system.  In this respect, I suggest that the price earnings ratio is chosen to evaluate the company in view of the popularity it entails in the market, since the disadvantages of both methods are similar.

References:

Answers.com. Tesco Plc (on line). Available from: http://www.answers.com/topic/tesco-plc-adr (Accessed 25th May 2007).

Institute for Transportation and Development Policy. Tesco Plc (on line). Available from: http://www.itdp.org/SR/read_SR/Tesco.pdf (Accessed 25th May 2007).

Kennon J. Price Earnings Ratio: A Quick and Dirty Way to Determine Relative Value, About.com (on line). Available from: http://beginnersinvest.about.com/cs/valueinvesting1/a/011101a.htm (Accessed 25th May 2007).

Pike R.; Neale B. (1999). Corporate Finance and Investment. Third Edition. London: Pearson Education Limited.

Randall H. (1999).  A Level Accounting.  Third Edition.  Great Britain:  Ashford Colour Press Ltd.

Reuters.com. Stock Quote – Tesco PLC TSCO.L (on line).  Available from: http://stocks.us.reuters.com/stocks/overview.asp?symbol=TSCO.L (Accessed 25th May 2007).

Tescocorporate.com. Financials – Five Year Summary (on line). Available from: http://www.tescocorporate.com/fiveyearsummary.htm (Accessed 25th May 2007).

Tesco PLC (2006). Annual Report and Financial Statements 2006 (on line). Available from: http://www.tescocorporate.com/images/Tesco_Report_2006_Full.pdf (Accessed 25th May 2007).