Chapter 1: Introduction 3
Chapter 2: Financial Performance and Position of TESCO 6
Chapter 3 Financial Management Policy 14
Chapter 4 Investment Strategy 18
Chapter 5 Valuation of TESCO 22
Chapter 6 Conclusion 26
Abstract
The present report provides critical analysis of financial positioning of Tesco Plc. For this, the financial data has been gathered for past five years as well as its competitors to critically assess financial positioning of Tesco in the retail industry. The reports highlight the recent issues of Bretix which has significantly impacted economic conditions of the United Kingdom leading to declining the consumer confidence because of triggering inflation. These factors have cast the negative impact on the retail industry as there is the significant decline in the growth of Tesco as well as other competitors in the industry. The report shares information about the Tesco’s historical financial performance as well as its competitors. Also, critical discussion about the financial policies of Tesco is done to gain insight into the financial information provided in the financial statements of the company. It is done to assess strategic positioning of Tesco in contemporary. Based on the results obtained it is concluded that the Tesco is strategically performing better than the other competitors in the industry. TESCO possibly encounters risks that more challenging requirements will be introduced to future legal and regulatory changes to the pension strategy and that the deficit could increase because of the inflation and the poor performance of its assets. The financial policies of Tesco anticipate the future needs. Dividend payout is lower than the other competitors, but the market value of the share price of Tesco is higher than the other competitors in the industry. Tesco is strategically anticipating strict cost control to anticipate the needs of customers and sales in the tough economic conditions.
Chapter 1: Introduction
In 2008 the worldwide economic crisis affected most countries, including the UK that was then one of the biggest economies in the world. UK economy experienced a great recession since then, with real GDP growth rate reducing from 2.6% in 2007 to -0.6% in 2008. The situation was even worse by the year of 2009 when GDP growth in the UK plugged to -4.3%. PWC, a multinational professional services network headquartered in London, UK, claimed that the economic recovery in the UK started off from the middle of 2009. UK contrived to deal with negative effects caused by the 2008 economic crisis, which was fully demonstrated by the tremendous rise in GDP growth rate, reaching 1.9% in 2010. Even though the growth rate is flexible and slow over these five years due to the slow consumer spending, particularly in the early phases of the recovery when consumers were hit by a “perfect storm” of rising VAT, high food and energy prices, and tough lending restrictions from banks, PWC explained, the GPD growth in UK ranks third of all G7 economies in 2015, behind Canada and the United States (see figure 1.1).
Consumer spending is the one of the two main sources of the relatively high GPD growth, which increased 3.3% in 2015. This growth are attributed to the low inflation rate, which fell to around zero, and the employment rate, which was 76.9%, 0.7% greater than that in 2014. Therefore, with more disposable money and bright prospects of the future, consumption confidence kept increasing since 2013, and it, undoubtedly, drives up the amount of consumption.PWC anticipated that the growth of consumer spending might be slow in 2016 because of the uncertainties caused by “Brexit” which now ails UK economy, especially on small individual companies.
Business investment is another critical driver, which, in 2015, rose 4.2%. The situation will not change without “Brexit”, the result of referendum, which now demonstrates two polar effects on business investments. With respect of foreign direct investment, it will be ailed for a short run due to uncertain government attitude toward them, however, if the UK government could provide a more friendly investment environment and favorable terms, investors who concern about setting up their headquarters in UK will not hold back their plans in a long run. But things will go to an opposite side regardingdomestic investment. Since UK no longer belongs to “single-market” created by European Union, domestic companies, especially financial ones, will face more obstacles such as tariffs and additional costs.
“Brexit” gives more possibilities for both UK and its economy. For simplifying the analyst of investment in TESCO, we will not take it into account, and discussthe investment plans under the recovery of UK economy that is promising according to the prediction of PWC.
2015 is an unusual year for retailing industry in UK because of the decrease of inflation and the online shopping trends as well. These two aspects experienced well trend over the year of 2015, which had a positive effect on the UK grocery retailing industry. Overall, UK did worse in 2015 showing that the amount spent in the retail industry decreased by 1.0% in December 2015 compared with December 2014 and decreased by 1.4% compared with November 2015. It is deeply affected by the zero inflation that the prices in December 2015 dropped 3.2% compared with the same period in 2014. It was the 18 consecutive month that year-on-year price fell. Falling in price would undoubtedly caused the increase in quantities, with 4.5% greater than 2014, but it is not large enough to offset the effect of price. There are only two types of stores that displayed an increase in amount, that are predominantly food store, such as TESCO and Walmart, and non-store retailing.
The rise in online shopping is a highlight in 2015 retailing industry, which accounted for 12.8% of all retailing sales.With the widespread of more online shopping apps, “Black Friday” and“Cyber Monday”, average weekly spending online in December 2015 reached £837.2 million; this was an increase of 8.2% compared with December 2014.
Together with the zero inflation rate and promising economic situation, consumer confidence peaked by the end of 2015 for nearly ten years. PWC anticipated that this trend would drive up the quantity in retailing industry, though the price remained subdued on both the high street and online.
TESCO is the largest retailor in UK. In the same industry, its competitors include ASDA, Sainsbury’s and Morrison’s, which are called the Big Four in UK.These four retailors take up almost 65% of the market share. In the year of 2014, the sales income (excluding VAT) of TESCO was£64,419,000 that was the highest one among the four retailors. The second wasSainsbury’s with £25,632,000 sales income. ASDA came after it with £23,670,000, which was followed by Morrison’swith £17,680,000. From the data, we could tell that TESCO had absolute advantages over the rest three retailors, having the sales income greater than the sum of the other three. In this heated competition, each retailors intends to reduce the premium of goods in order to win more price sensitive customers, and it may reduce differences of the quality of goods and the price as well among these companies.
Convenience stores are another type of competitors of TESCO. The popularity of them is due to the shopping mode transferring to more trips for fewer items, especially under the economic phenomenon that little price distinction taken place. Besides, since the convenience stores are much smaller than regular supermarkets, customer could gain better shopping experience with one colleague serving more customers. However, bounded by the size of convenience stores, the ranges of goods are not widely enough to fulfill customers’ satisfaction, and sometimes the rent of a rack for one good is even higher than that in supermarket. Therefore, supermarket is still the main trend in grocery retailing industry until another type of market with every aspect superior than supermarket exists.
Based on the above data and prediction, UK is still one of the strongest economies in the world; it will provide retailing companies with more flexible and comfortable atmosphere for improvement. On the background of it, each company has its space to develop. Grocery retailing industry is one of the most important sectors in UK economy; it directly reflects customers’ expectation of the economy. The top ranked retailors do their best to regain and strengthen the market here. Investing in retailing industry may be good chance for investors.
Chapter 2: Financial Performance and Position of TESCO
TESCO is the largest retailer in the world, with £69.7bn group salesand £1.4bn group trading profit. UK is the essential battleground of ESCO, which contributes to almost two thirds of total sales income. In 2015, the sales income of UK was £48,231m declining 1.7%. Asian, with larger population than UK, has £10,501m income sales. As for sales profits in UK, it is £467m, only £97m less than that in Asian. There is no doubt that TESCO claimed to start adjusting its strategies from UK in Annual Report and Financial Statement 2015. “The reported yearhas been both an extremely challenging year for Tesco and a year in which we began a process of considerable change.” Alan Stewart, the chief financial manager, said in the Annual Report. By introducing like-for-like sales model, some financial indicators, such as sales income, sales profit, are heavily affected. The first three quarter of like-for–like sales performance is barely tolerable, with declination greater than 3.7%, which indicated that the sales income plugged more than 3.7% by taking all activities affected both 2014 and 2015 into account. The situation was better in the last quarter, which represents an encouraging response to the customer-focused initiatives launched in the third quarter.
On top of that, TESCO faced many other risks that led a decrease in its sales, and set up strategic priorities. These risks caused great problems for TESCO. Not providing as excellent service as customers’ expectation is the most important one. TESCO indicated loyal customer was a 2.5% decline, which somehow conducted to the declination of sales incomes. In order to fix this problem, TESCO decided to re-position its business on customer service, to reduce prices, to expand ranges of goods, etc. Additionally, TESCO also had strategies to improve mutual trust between itself and colleagues, as well as with suppliers, and shareholders. Committing to being more open, transparent is considered as another key to successful business. The last one is to protect and strengthen its financial position by reducing debts, regaining sole ownership of supermarkets, etc. Alan believed the three priorities could help TESCO to restore UK competitiveness.
Earning Per Share, which is also known as EPS, is a ratio of a company’s net income that is allotted to average outstanding share of common stock. Basic EPS (or simply EPS) and diluted EPS are the two basic types. Unlike basic EPS, diluted EPS takes all convertible securities into account, for instance all outstanding convertible preferred shares, convertible debt, equity options, etc. Therefore some directors consider that diluted EPS is preferable with its being a more conservative number that calculates EPS. In this essay, I adopt this opinion, in other words, using diluted EPS for deep research. Being an important indicator of a company’s profitability, EPS is always included in this company’s annual report. For accuracy and simplification, I derived the data from the annual reports of TESCO and its two rival, Sainsbury’s and Morrison’s① (see as table 2.1). Although EPS is critical in profitable analyst, it’s often used to be a variable to estimate P/E ratio (Price/ Earning ratio) for EPS alone cannot give more valuable information.
P/E ratio, which is abbreviated for Price/ Earning ratio, is a ratio used for measuring a company’s current share price relative to its per share earnings. The equation of this ratio is: P/E ratio= Market Value per share/ Earnings per share. Based on which EPS is used, there are two main types of P/E ratio. One is trailing P/E ratio, which is calculated using EPS from the last four quarters, and another one is projected or forward P/E ratio, which is calculated using EPS from estimated earnings expected over the next four quarters. The former one, trailing P/E ratio, is more popular and adoptable in analyst, hence, we would use trailing P/E ratio for discussion.
In addition to EPS, share price is another important element in P/E ratio. Here, I use the weighted average share price over the course of 2015 as the numerator in order to get the annual P/E ratio. By applying the equation, P/E ratios of the three companies are shown in table 2.1.
(Unit: pence)
1. Some factors, such as company growth rates, industry, could affect the efficiency of P/E ratio. The companies under discussion are all from the same industry in UK, so in the context, we could eliminate the effect of industry. Compared their sales growth rates (see table 2.2), TESCO’s growth rate ranks first, which the ranking go according to the P/E ratio. So P/E ratio correctly reflects the economic situation among these three companies. The financials ratio are calculated to compare financial positioning of Tesco with its competitors. On the basis of the results obtained, it can be noted that the share price of Sainsbury is higher than Tesco. But the P/E ratio of Tesco is highest among others. It shows that besides that share price of the Tesco is lower than other competitors but the earning per share of Tesco was highest than the other competitors. It reflects that the Tesco has earning more than other competitors in the industry over its four quarters. The shareholder’s confidence on Tesco would be eventually more because the earning P/E of Tesco is highest as compared to other competitors. Besides the EPS ratio of Sainsbury is higher but the P/E ratio shows that the Tesco’s share price is highest as compared to other competitors in the industry. It is because of the reason that the market value of Tesco’s share price is higher than the other competitors.
(Unit: percentage)
2. Looking at the sales growth figures, it can be noted that all the competitors faced negative sales growth. Since, all the competitors in the industry show a negative sales growth. It may be because of the economic conditions that has suppressed the consumer confidence. The decline in the consumer spending on retail goods may be because of the poor economic conditions. Besides the fact that all the competitors face negative sales growth but Tesco’s sales growth figure show that it face with the lesser negative decline in the sales as compared to other competitors. Sainsbury had the highest negative sales growth which is indicative of the face that the sales of Sainsbury declined at the faster pace than Tesco and Morrision. As seen from the figures that the sales growth of Tesco was -1.4, whereas Sainsbury had -4.3 Given that these three companies are in the same industry, in the year of 2015 when the inflation is almost zero, P/E ratio could indicates the pound amount an investor can invest in a company so as to receive one pound of that company’s net income. That is to say an investor would like to invest 23.31 pounds in TESCO, or 11.28 pounds in Sainsbury’s, or 19.65 pounds in Morrison’s, for only 1 pound earning in the coming future. From the financial figures, it can be noted that the sales growth are determined on other factors which involves the strategic positioning of the company in the industry. From the results obtained, it can be said that the economic conditions are overall poor because consumer’s confidence has declined. But Tesco is strategically sound to develop its strategies to sustain its sales volume. It can be determined on the basis of the sales growth and the market value of the share prices of Tesco. In the tough, economic conditions Tesco is still strategically performing better than the other competitors in the industry.
3. Generally, higher P/E ratio means that investor have a higher expectation in the company’s future income. Comparing with the P/E ratios of Sainsbury’s and Morrison’s, investors obviously have confidence in TESCO’s operation in the coming year with 12.03 higher than Sainsbury’s and 3.66 higher than Morrison’s.
Above all, the P/E ratio of TESCO shows a promising future among investors. Since, the P/E ratio of Tesco is higher than the other competitors it is indicative of the fact that the profits gained from the investment in the shares of Tesco would yield greater profits than other competitors in the industry.
Although P/E ratio provides investors valuable information of investment, the P/E ratio has its shortcoming that is giving the investment expectation in the short run. For long run analyst, the abnormal buy-and-hold return is a better choice. Just like Barber and Lyon (1997) and Lyon, Barber, Tsai (1999) claimed that ABHRs are essential since they “precisely measure investor experience”, and “match the investors experience.” The abnormal buy-and-hold return (ABHR) refers to the differences between the realized buy-and-hold return and the normal buy-and-hold return. It uses geometric returns instead of arithmetic returns to calculate the total return over the event period of interest. Based on the definition of ABHR, the equation is:
ABHRi=∏Nt=1(1+ri,t)-∏Nt=1(1+rbenchmark,t) (1)
where ri,tis the month t simple return of the i company stock, and rbenchmark;t is the corresponding return for the benchmark portfolio.
The function of monthly simple return is
ri,t= (P1-P0)/P0 (2)
where P1 is a second month adjusted closing price, P0 is a first month adjusted closing price.
rbenchmark;tcan be measured as FTSE 100, a market index.FTSE is a share index of the 100 economies on the London Stock Exchange. These companies all have the highest market capitalization and TESCO is one of them.
Since ABHR is more accurate by applying 24-36 month-period data, we chose the stock price data from 2013-2015(36 months). Then N=36, and i=1.
Using (1) and (2), the ABHR is -56.83%. From the negative ABHR, we could tell that: the normal buy-and-hold return exceeds the realized buy-and-hold return, which implies that the stock price of TESCO was undervalued by the investors.
Employing the same procedure, the ABHR of Sainsbury’s is -18.35%:
The ABHR of Morrison’s is-37.67%
Hence, the average ABHR can be calculated using the following function:
AABHR=1/n∑ni=1ABHRi(3)
and the result is -37.61%.
The significance of these overall ABHR is ascertained by employing the calculation of a t-test, which is defined as follows:
tABHR=AABHR/(σABHR/√n) (4)
where tABHRis t-test
AABHR is average ABHR
σABHRis the sample standard deviation of ABHR
n is sample size
The null hypothesis is AABHR= 0, then tABHRequals 9.19 which implies rejecting the null test.
In accordance with what we discuss beforehand, TESCO experienced slow development in the course of these five years, which is shown directly by the profit before tax. (See table 2.4).
(Unit: Billion Pound)
Therefore the ABHR does not give the right prediction in the long run. In such case it is due to the weaknesses of ABHR as following:
1. ABHR is easily affected by the inaccuracy of data. Fama and Mitchell claim that it is not a good indicator for long run abnormal. For example the 2012 data is somehow not abnormal and the rest are normal, then BHAR demonstrates abnormal behavior for the rest two years. Therefore in order to fix this problem, we should test ABHR of 2014 and 2015 separately. However, given the above data it is difficult to tell the abnormal data from the normal one, little evidence is provided to improve the accuracy of ABHR. Further more, because this problem is easy to deal with, it is no longer a core problem for ABHR methodology when employed to individual stocks.
2. Anotherthat leads to the unreliability of BHAR is statistical problem. The aforementioned issue could be adjusted by bootstrapping. However a cross-correlation problem is often observed in most cases and difficult to address by using bootstrapping. As Mitchell and Stanford demonstrated, regarding to the average ABHR, even a seemingly small change in cross-correlation could cause significant changes the t-test and the power of test.
Overall ABHR could cause serious problems by introducing many inferences in long run studies. Just as Mitchell and Stanford sum up that "BHAR methodology, in its traditional form, should not be used for statistical inferences. Nonetheless since it matches investors’ expectation, it is still widely used.
Chapter 3 Financial Management Policy
In order to give a deep analyst on the changes of dividend policies of TESCO, we have to, at first, introduce two simple and basic parameters. The first one is “Dividend per share”. It is also known as DPS, which is the total amount of declared dividends for every ordinary share issued over the course of a whole year. DPS can be calculated by the following formula:
DPS=(D-SD)/S (3)
D: Sum of dividends over a period (usually 1 year)
SD: Special, one-time dividends
S: Shares outstanding for the period
On every annual report, TESCO publishes its DPSs, which, in the year of 2011, was 14.46 pence, and stick to 14.67 pence for the coming three years. However, DPS plugged to 1.16 pence over the course of 2015. This was because of the sluggish improvement of profits in 2015 when the trading profits £m 2bm lower than that in 2014.
Payout ratio is another crucial tool to learn financial management policy. Payout ratio is a ratio of earning that is paid out to shareholders in term of dividends. It is typically in form of percentage, and is also known as dividends paid out as a percentage of cash flow. The payout ratio could be used to check the sustainability of a company’s dividend payments. Therefore, the low payout ratio is preferable than the higher one for the former means a company pays less than the later. If it is over 100 percent, then a company will pay more than what it earns. The formula of payout ratio is:
Payout Ratio = DPS / EPS (4)
where DPS: dividend per share
EPS: earning per share
In order to keep the consistency of the discussion and make the result more accurate, here we choose diluted EPS, the ones used in chapter 1, to calculate payout ratio, and the result is displayed on table 3.1. From 2011 to 2013, the payout ratio was fluctuated around 40% while starting from 2014, it became to decrease, and was 28.36% in 2014, 12.31% in 2015. Although the dividend per share decreased a lot in 2015, the earning per share reduced faster than it, the actual payout ratio in 2015 is the largest which means that only 12.36 percent of its earning was given to stockholders as dividends. Actually because of the steady earnings growth, the payout ratio is remarkably stable from 2011 to 2013. This change happened as the same reason as that of reduction of dividend per share. It is indicative of the fact that the company is paying lesser amount of dividend to its shareholder but the overall performance of Tesco is higher than the other competitors in order to sustain market value and promising profits in the futures. The companies that pay higher dividend even when the financial performance of the company is to temporary boost investor’s confidence. Tesco is not manipulating its investors through paying higher dividends but rather it is more focuses to sustain share value of the company by retaining its earning. It is indicative of the fact that the Tesco’s share price would be more secure and profitable in the future. Herein, it can be said that the investment in the shares of Tesco would be beneficial for the shareholders in long run. It indicates that the investment in the Tesco holds greater shareholder’s confidence through maintaining its share value.
Dividend policies refers to financial policies concerning about how much of its earnings will be paid to shareholders. What amount, how to issue or whether to issue dividends, is determined by the company’s finance situation (cash flow) and affected by the company’s long-term earning power.TESCO claimed report that “As announced in January, the Board has taken the decision not to recommend a final dividend, with the full year dividend charge solely reflecting the interim dividend of 1.16p paid on 19 December 2014. Future dividends will be considered within the context of the performance of the Group, free cash flow generation and the level of indebtedness.”(TESCO Annual Report and Financial Statement, 2015) This is the biggest adjustment for the dividend policy in 2015 and is supposed to protect the company and have a good starting for the coming year that. For example, if the earning is less than expected by the end of 2015, by not paying a final dividend, the situation would not be worse, which means the company would have more cash flow to make the business better by using the cash in the ways that could improve profits.
TESCO met a lot more risks. First up, TESCO had -£ 8.5bm debt 29 percent greater than that in 2014. Therefore, TESCO dose not have a clear and sustainable financial strategy, which could give the pressure to cash flow. Under this situation, TESCO may encounter the probability of running out of cash and having greater debts than expectation. Thus, TESCO decided to set up “a clear plan to address and control retail space, re-purpose space effectively where needed and ensure the right balance between freehold and leasehold space ”(TESCO Annual Report and Financial Statement, 2015)
Second, TESCO possibly encounters risks that more difficult requirements will be introduced to future legal and regulatory changes to the pension strategy, and that the deficit could increase because of the inflation and the poor performance of its assets. (This would be more severe when UK exited Europe Union who withdrew funds.) So TESCO would cooperates with external expert advisors and apply the pension scheme to take the funding position, fund performance of the pension, etc. into account.
Last but not least, capital structure of TESCO should be taken into consideration. The capital structure is a way that a firm funds its activities and growth by using different sources of funds. It includes retained profits, debt capital market issues, commercial paper, bank borrowings, disposals of property assets and leases.The capital structure of TESCO is as followed (see table 3.2):
We can tell from the above chart that in 2015, every aspect is worse than that of 2014 besides net derivative financial instruments. The number of debt is almost 20% more than that of 2014. This is, again, due to the reduction of profits in 2015, which means that by the end of each year, TESCO had to pay back all these debts which undoubtedly would decreases the profits of the company and drive the company into a more passive situation without money to do other investment. In order to change this situation, to maintain or change the capital structure, TESCO decided to “adjust the dividend payment to shareholders, buy back shares and cancel them, or issue new shares.” (TESCO Annual Report and Financial Statement, 2015)
Chapter 4 Investment Strategy
Being one of the world’s biggest retailers, TESCO has always contributed to its core value, which is committing to using its scale for goods by acting as a responsible, valuable and social-friendly retailer. TESCO’s lead position in its field is due to its consistent passion and investment in customers, shopping trip and colleagues. TESCO claimed that by improving its customers’ loyalty, shopping experience and working environment and by reducing the good’s price, it could earn a much steadier position among the market. In September 2011, TESCO, for instance, invested over £500 million to reduce the prices of over 3,000 everyday products, which was called Big Price Drop at that time and attracted more customers than its peers in that specific month. Similarly, in the year of 2015, in accordance with its three priorities to improve TESCO for customers, it have committed to reinvest any saving or outperformance into further improvement in its shopping trip. TESCO said: “The reason for this reinvestment is clear: the better we do for customers, the more we will improve our sales, and the more our sales improve, the more we can invest further in the shopping trip”.
In order to maintain a long run business success, TESCO has its clear vision to show the way for improvement. In an increasingly competitive environment, without the clear vision, one company is hard to sustain its business and could lose its competitiveness to its rivals. The vision that TESCO holds is that: ”To be the most highly valued business by: the customers we serve, the communities in which we operate, our loyal and committed colleagues and of course, our shareholders.” Following the vision TESCO sets up its strategies every year (see table 4.1).
Main Investment Strategies during 2011 to 2015
In order to have a clear understanding of the impact of these strategies, we first introduce some basic concepts we need. The first one is dividend policy, which is the set of guidelines that a company employs so as to decide how much of its earnings it will pay out to its shareholders. We could use the dividend per share to show the changes of dividend policy during 2011 to 2015 (see table 4.2).
(Unit: Pence)
It is quite outstanding that before the year of 2014, the dividend policy was quiet steady, maintaining around 14.76 pence. Compared with its corresponding strategies, TESCO’s strategies did not experience large changes ahead of 2014, continuously focusing on premium goods, customer service, colleagues improvement, with at least 4 strategies for a whole year. But changes happened in the year of 2015. It is not only because of the sluggish economic growth, but also because of the change of its core strategies, for example, less attention are paid on customers position than before.
The second concept we introduce is KPI. KPI, which is short for Key performance indicators, are the main index used to valuate the business performance. KPIs are employed to assess current performance by making comparisons with previous performance and they help managers respond when targets are not being met. The following table (see table 4.3) shows how TESCO monitored its performance against targets using KPIs for the 2012-2015 period.
The table clearly shows the impacts of its strategies. Although TESCO continuously invests in customer service, colleagues training in these four years, the effects of them did not help with improvement, and even made the situation worse as time went by, such as the customer satisfaction decreased in 2015, like-for-like sales growth and trading profits were always below the targets. However working capital improvement experienced a positive trend with gradually increasing during these four years. Realizing the weaknesses of its development model, TESCO claimed that it would devote more time in regaining the loyalty of its customers and mutual trust from its colleagues and suppliers, which was one of the three priorities in 2015.
Chapter 5 Valuation of TESCO
There are a lot of approaches that can be used to give the estimation of the value of TESCO. Taking the theoretical basis and the implementation into consideration, approaches have their advantages and disadvantages.
At the beginning of this section, two models are introduced - the dividend model, and the free cash flow model, which are on the basis of a strong theoretical approach called the discounted cash flow approach, into analysis and then employ multipliers for double-checking.The earnings and investment model, which is also a useful model, is not included in the following discussion.By applying these models or approaches, we want to have deep insight of the value of the company thus we could make the final investment plan.
The discounted cash flow principle (DCF)is a valuation approach, which is employed to estimate the attractiveness of an investment opportunity. By applying the future cash flow projections and discounting them to arrive at present value estimation, we could forecast the potential for investment. In accordance with the definition, the function of the discounted cash flow is as followed:
DCF= CF1/(1+R)1+CF2/(1+r)2++CFn/(1+r)n (5)
where CF is the future cash flow
r is the discount rate (WACC)
After the simple calculation, we could obtain the value of DCF. Forthwith the previous procedure, comparison between DCF and the current cost of the investment could be made. If DCF is higher than the current cost of the investment, it would be a good opportunity to invest, and vise versa.
Since DCF produces the closest thing to an intrinsic stock value and help investors with clearly understanding of the true value of a company, it is widely accepted by many investors, especially the starters. However, it has some shortcomings, which make it a little bit difficult to implement. First, for most starters it would fluctuate strongly simply depend on how well you believe the company operates. If you believe that the company has a bright future, let say, the future cash flow may be larger, and DCF would lacks its accuracy and is no longer useful for estimation. Second, DCF could be calculated under the situation that the future cash flow and the discount rate are given. If there is no such transparency of this company which means that the necessary information is not provided, then it may be hard to use DCF for prediction. Last, DCF is not a good model for short run investing. It fits for the long-term investment. Overvaluing DCF may make you miss some unusual opportunities in the long run. Compared with P/E ratio, DCF could give you the true value of a company even though a lot of calculation and assumptions are needed. DCF model regards a company as a business instead of a ticker symbol and a strock price, providing you further thought of the many factors that will affect a company’s operation.
Based on DCF, we now introduce three models to estimate the value of the company. The dividend model, which is also known as the dividend discount model (DDM), is a methodology of estimating a business’s stock price based on discounted cash flow principle. The main idea of this model is to use the net present value of the future dividends to value shares. That means DCF is used to value stocks relied on the net present value of the future dividends.Based on its definition, the function of DDM is as following:
V0=D1/(1+r)+D2/(1+r)2++DN/(1+r)N+VN/(1+r)N(6)
where DN is the n year dividend per share
r is the discount rate
VN is the terminal value of stock, which is given by
VN=DN+1/(r-g) (7)
g is the dividend growth rate
The most popular way of valuing DDM is called the Gordon growth model. This model values a company’s stock under an assumption of constant growth in payments that a company generates to its common equity shareholders. The function is:
V0=D1/(r-g) (8)
Function (7) could be simplified into function (8). The simplification is:
Since D2=D1(1+g), D3=D1(1+g)2,, DN=D1(1+g)N-1, DN+1=D1(1+g)N,substituting it into (7), we could have function (8) as a result.
There are three key inputs in the model, including DN+1, g and r. Beside, the Gordon growth model assumes that a company exists perpetually and pays dividends per share that increase at a constant rate. In order to predict the evaluation of a stock, the model assumes that there are endless series of dividends per share and discounts them back into the present by applying the discount rate r. Putting TESCO under discussion, V0is the dividend per share in 2015 which is 1.16 pence, r is the discount rate which is 3.7%, g is the dividend growth rate which is 2.4%, then V0is equal to 1.16*(3.7%-2.4%)=0.015, in other words, the expected dividend per share in 2016 is 0.015 pence which is much lower than that of 2015. Because of that, investors would not like to invest in TESCO any more.
There are some limitations of the Gordon growth model. First it is very rare to have constant growth in one company’s dividends since it would changes according to current economic situation and the operation. Second, there is an issue between the discount rate and the dividend growth rate. If the former one is smaller than the latter one, this model would be worthless for no investors would pay extra money to the company. And the result would be infinite if they are equal. Moreover, this model will work effectively in long run, but since we lack promotional information, this model may not be very accurate. Accompanied with what we conclude as before, people undervalue TESCO stocks so that the investment would decrease in the following years, which has the same conclusion as the Gordon growth model.
Because of the shortcomings of the dividend model, now another alternative model, free cash flow (FCF) is employed into discussion. Free cash flow refers to the cash flow that a company is capable to create after arranging the money required to maintain or expand its asset. It is very essential for it helps a company to grasp chances that could possibly strengthen its shareholders’ interest. Cash could help a company with its development, investment, acquisitions, dividends payment and debt reduction. But from the latest TESCO annual report, its debt was even larger than ever before, which implies that TESCO has less cash in hand, and therefore it would has a deep impact on operating activities and shareholders’ confidence as well.
Free cash flow model aims at the free cash flow to the company (FCFF), or the free cash flow to the equity (FCFE). Free cash flow to the company (FCFF) refers to the cash flows that are available to the shareholders, company’s capital lenders, and all the parties providing the company’s funding. It helps the company get full understanding of the value of a company’s weighted average cost of capital. Free cash flow to the equity (FCFE) is used to predict the cash flow has been covered. Here, the cash flow refers to the one that are left to the shareholders after all activities, including payments to all the suppliers of funding. A company’s equity cost of capital is a vital element to value FCFE.
Generally, under the same assumption, it could have a similar result as the dividend discount model. But since the free cash flow is a much more detailed approach in developing the net cash flow estimation, it is likely to have detailed result derived from the dividend discount model. Meanwhile, the assumptions should not be constrained to that of the dividend discount model.
Applying the definition of FCFF, the function of it is as following:
Firm value=∑nt=1FCFF/(1-r)t (9)
where FCFF is the free cash flow to the company, whose function is as following:
FCFFt= EBIT(1-t)+Depreciation-Capital Expenditure-Increase in NWC
= Net Earning available to equity+ Interest (1-t)+Depreciation
-Capital Expenditure-Increase in NWC
r is the discount rate;
n is the number of year
According to the function, the following two elements are required:
1. An estimation of the cash flow which equal that its expected revenue minus operating cost and tax payment (see table 5.1)
2. The discount rate
(Unit: Million Pound)
Applying function (9), the firm value is -603.1 million pounds. It implies that the exact firm value is lower than expectation. “This would put further pressure on free cash flow and impact its ability to improve credit rating.” (TESCO Annual Report and Financial Statement, 2015) In order to make thing better, all TESCO plans and budgets are presented to its Executive Committee and Board for approval to ensure targets and objectives are consistent. TESCO also claim that it will employ external expert advisors and the pension scheme Trustee to deal with the funding position and performance. (TESCO Annual Report and Financial Statement, 2015)
Chapter 6 Conclusion
After 2008 worldwide economic crisis, each sector was deeply affected, experiencing plug. Things did not go well until mid 2009. It was at that time that UK economy and the global economy started to change to be better. In order to rule out the effect of 2008 economic crisis, this essay discussed everything over the course of 2011 to 2015. Then the UK economy experienced recovery over the period of 2011 to 2015. Each department had chances and challenges to make vast improvements. Under this situation, people’s confidence on the economy was much brighter than before, which leads the consumer spending keep increasing for the several years. As time goes by, the international politic affairs would have either positive or negative effect on economy. In the year of 2016, UK decided to leave European, which was known as “Brexit”, this caused a lot of heated discussion on UK economy and the UN economy as well. Since the effect was still unknown to every sectors and companies, in order to simplify discussion, this is eliminated for the background. The imperative impact of Brexit on the retail industry is substantial. The economic sanctions and barriers have implicitly increased due to Brexit which may lead to increase in the overall costs. These all factors would collectively impact the economic growth of retail industry as well as Tesco. To ensure growth in the prevailing economic conditions it is important that the organization needs to strength its strategic decisions. Financing policies and decisions of the organization are the major factor that needs to be assessed.
In general, TESCO was the biggest retail organization in grocery retailer in UK. Compared with its rivals, let say Sainsbury’s and Morrison’s, it has demonstrated advantages and ran more successful business than them. It is demonstrated not only on its sales figures such as sales income, net profit, but also on investor’s confidence that is related to what we discuss after. Going over the history of TESCO and its annual reports, one thing is confirmed that this success is not only coming about by chances but is also the result of outstanding leadership and management. These factors are necessary for its success. With deep inspection of its annual reports, its success is also attributed to the clear vision and challenging strategies, which is used to satisfied the change of modern world. On the basis of historical data of Tesco, it can be determined that Tesco throughout time has sustained a dominant position in the retail industry. However, the strategic decisions of the company needs greater improvement as the sales volumes of the company have dropped because of overlooking customer’s needs. Though, the financials depict profitability of Tesco but adding value is important factor that should not be overlooked by the company through addressing needs of customers. Though, Tesco has maintained its profits through strict control on costs but it has overlook needs of its customers which has eventually declined sales volume.
After the calculation, we then start discuss the financial policies and strategies. Using the same technique, comparing, we have a deep understanding of its strategies and the difference among its rivals. We have to confess that, even though it met a decrease in 2015, it still behaves well comparing with its competitors. Tesco has been constantly bringing changes in its strategies to improve its performance among its competitors. All aspects of its business are well organized and when necessary, plans are adapted to make sure that targets are finally met. Being a successful retailer is not the only one goal for TESCO, it also wants to be a socially responsible retailer by committing parts of investment in environment. Every decision taken into consideration is supposed to make sure that customer, communities, suppliers and staff would have excellent experience with TESCO. Noticing its shortcoming in business and analyzing the problems, TESCO came up with more useful strategies to improve every single aspects of its operation. And this will need a long time to check its impacts.
Having known its strategies, we then discuss the valuation of TESCO by using two basic models, one is dividend discount model, and another one is free cash flow model. Even thought these models both have its shortcomings, it did help to improve investors’ understanding of a company and help with long run investment plans. After the discussion of these models, a conclusion was draw that a rational investor will not invest in TESCO stock though its board shows positive opinions about its future. Due to this situation, TESCO came up with many financial strategies to fix these problems. Whether this strategies would work or not, the 2016 annual report would tell the result.
All in all, through analyzing the data of TESCO, a clear understanding for its investors could be formed. On the background of global prosperity, TESCO did experienced great improvement for the first several years. However, because of paying more attention to strategies that were not such important, it had a sluggish improvement for the coming few years. Luckily, the board understood the weaknesses and mistakes made in the procedure, and decided to change it. But this will not provide investors more confidence in the short run, and may only works in the very long run. Therefore, what important for TESCO is to keep changing, this is the only method that could help TESCO survive and strengthen its first rank in grocery retailing industry.
Finally, since the above analysis is only based on some data deriving from TESCO’s annual reports, the company may adjust some data in order to make the problems easily understood for its shareholders. Hence, there exists some inaccuracy by using these data, and a lot of improvements may be adopted in constructing different models or functions.
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