3.

VALUATION OF THE COMPANY

A vast spectrum of literature has evolved during the years concerning the valuation of

an organisation. A number of methods will be utilised in this paper, namely the net

asset valuation approach, the earnings stream method, the dividend model, the

economic value added scheme and the free cash flow model. These will be computed

and discussed in the proceeding sub-sections.

3.1 Net Asset Valuation Approach

Under such an approach, the net asset value of the organisation is sought to represent

the value of the company. In 2009, the net asset value of Tesco amounted to £12,938

million (£46,053 - £33,115). If one divides this figure by the weighted average

number of ordinary shares of 7,859 million, one can translate such value on a per

share basis. This is conducted below:

Under the

efficient market hypothesis, this posits that in a strong market, the current price

reflects all pertinent information, being past, public and private data. The stock price

reflects the true and intrinsic value of the share relying on future cash flows. In this

type of market arbitrage cannot take place and speculation for capital gains purposes

is futile (Pike et al. 1999). Therefore, in a strong market, under such premise, the

share price reflects the value of the company. If one compares the present share price

of Tesco standing at £4.18, one can note that such figure is much higher than the one

computed above (Reuters.com 2009). This stems from the weaknesses of the net

asset valuation approach, which rely on accounting data. Financial accounting is

prepared in accordance with a number of international accounting standards. Such

standards are highly conservative and prohibit the recording of certain items despite

they are present in the business environment and affect the valuation of a company.

For example, IAS 38 – Intangible Assets states that internally generated intangible

assets like goodwill cannot be recorded in the accounts due to their subjectivity (Finch

2008). Thus, it is wise to adopt more methods like the ones outlined above to provide

a more realistic figure of the company’s value.

3.2 The Earnings Stream Method

This model relies on the price-earnings ratio, which is an investors’ ratio computed in

Appendix A and discussed in sub-section 2.4. In such method, a benchmark price-

earnings ratio is adopted in order to outline any under or over-valuations resulting on

the company’s share price. Under such method, inefficient markets are being

considered contrary to the efficient market hypothesis (Pike et al. 1999). In this case,

the benchmark price-earnings ratio will be the industry average of £4.47. Tesco’s

price-earnings ratio of £15.17, which is much higher than the industry average.

However, on the contrary, the earnings per share of Tesco of £0.28 are much lower

than the industry average of £0.73. Such disparity outlines that the company’s share

value is out of line. Abiding with the industry average being the one correctly valued,

the benchmark share price stands at £3.26 (£4.47 x 0.73). The present share price of

Tesco under such method stands at £4.25 (£15.17 x 0.28), which implies that Tesco’s

share price is over valued and should fall in the nearby future when the market is at

equilibrium.

The Earnings Stream Method is often criticised due to the arbitrage present in the

computation of accounting profit. One has to remember that accounting profit is a

key figure that affects the earnings per share, which in turn influences the price-

earnings ratio. Such arbitrariness stems from provisions like depreciation that are
based on historical prices and the accounting of material expenditure under the

exceptional heading (Lewis et al. 1996).

3.3 The Dividend Model

In Appendix A, a dividend growth was noted by the increase in the dividend per share.

Therefore, the dividend growth model should be applied, which contends that the

share price of an organisation is the sum of all discounted dividends, growing at an

annual rate (Pike et al. 1999). In order to compute the dividend growth model one has

to determine the cost of capital of the organisation in order to discount future cash

flows. The equation commonly used is the following (Pike et al. 1999):

Cost of Capital = Rf + β(Rm – Rf)

Where:

Rf is the risk free rate of interest of 4.25% (Insight-Investment 2009)

Β is the Beta of 0.77 (Reuters.com 2009)

Rm is the historical return of the stock market of 15.9% (sharemeastro 2009)

Using the above computations, the cost of capital amounts to the following:

Cost of Capital = 4.25% + 0.77(15.9% - 4.25%)

Cost of Capital = 13.22%

A period similar to the one used for the financial analysis will be applied of five years.

In the past five years, the dividend per share increased by £0.01 per share per year,

leading to the following percentage increases:

Year Percentage Increase

2009 9.09%

2008 10%

2007 11.11%

2006 12.5%

Table 3.1
The average increase amounts to 10.68%, which will be the growth rate utilised for

the dividend growth model. The present dividend is also used in the equation, which

in Appendix A amounts to £943 million. In this respect, the value of the shares

amounts to the following:

Share Value = £925.38 + £901.17 + £880.95 + £861.18 + £841.86

Share Value = £4,410.54 million

Dividing this by the weighted average number of shares leads to a share price of:

4,410 .54
Value of Company per Share = = £0.56
The dividend 7,859

growth model also encompasses limitations, mainly arising out of its key premise and

assumptions undertaken. The entire model is based on the dividend paid by the

company. Dividends, despite being a common trend are not always paid in all the

years. It is not a rare occasion that organisations refrain from paying dividend in

order to lead to capital appreciation. If this is the case under this model the company

has no value, which is highly unrealistic. This method presumes that there will

always be viable projects to sustain the earnings available for retention and meet the

envisaged dividend payment. In reality this is not always case and it is not rare that

dividends are reduced or absent during adverse trading conditions, like the one

presently affecting the United Kingdom. The arithmetic of the dividend model is

based on the premise that the cost of capital is greater than the dividend growth rate.

If the growth rate is higher than the cost of capital, which may be the case,

excessively high figures will be derived from this model, leading again to unrealistic

valuations. Advocates of this model defend it against this contention by stating that in
such instances the long-term average growth should be taken rather than this sudden

growth (Pike et al. 1999).

3.4 The Economic Value Added

The economic value added (EVA) concept was considered very favourably in the

financial world from its inception. This method further refines the earnings idea by

computing the residual income, which encompasses the true economic profit of the

organisation after the cost of capital for the assets devoted is deducted (Pike et al.

1999). Applying this method to the company at hand, the non-current tangible asset

base of Tesco amounts to £24,691 million and the cost of capital will amount to

£3,264.15 million (£46,053 x 13.22%). Therefore the residual income stands at -

£1,098.15 (£2,166 - £3,264.15). In such a stance, the financial performance of the

organisation is incapable of generating profits in excess of the cost of capital and this

will have an adverse affect on the share price of the company, leading to deterioration

in its value.

The main limitation of this method of valuation is that it hinders growth within the

organisation. Managers may be reluctant to adopt growth strategies, because a higher

cost of capital will be charged. Capital projects do not always provide an immediate

return and there is the risk that a negative residual income will be attained during

periods when the investment will be undertaken. However, this does not necessarily

mean that these are bad investment decisions, because in the future such projects will

lead to increases in financial wealth (Clayton 1999). Thus during such periods, the

company may be negatively valued if such method is adopted.

3.5 The Free Cash Flow Model

The free cash flow model is based on the same premise of the dividend model, which

entails that the value of an organisation depends on the stream of benefits that the
investor expects to attain from such investment. The difference between the two that

separates such methods is that the dividend model is based on dividends provided,

while the free cash flow on the free cash flow of the organisation. Like the dividend

model, the free cash flow premise discounts future free cash flow in line with the set

cost of capital, which was computed in sub-section 3.3. This discount stems from the

time value of money premise, which contends that £1 today is more valuable than £1

next year. Therefore, future cash flows are discounted to reflect the loss in value

arising from inflation, opportunity cost and other economic elements (Pike et al.

1999).

The computation of the free cash flow commences from the operating profits that the

organisation generates after deducting corporation tax expenditure. However, in such

profit figure there are non-cash transactions that ought to be adjusted, like

depreciation. These figures are added to the net operating profit after taxation.

Further more, the free cash flow is determined after deducting the capital expenditure

and considering the movements in working capital. Like the dividend model, the free

cash flow method necessitates consideration of a specific time, which is the same as

that of the dividend model of five years (Pike et al. 1999). In this respect projects of

the free cash flow for the next five years are determined, which serve as a yardstick to

compute the market value of the company. All these computations are portrayed in a

spreadsheet outlined as Appendix C.

Based on the computations in Appendix C the value of Tesco PLC is £2,191. Based

on the weighted average number of shares a share price is determined of:

The free cash

flow model relies on cash flow, which is a very important element for an organisation.
It is commonly contended in finance that cash is the lifeblood for the organisation and

without it the firm will perish quickly. This sustains the notion that an organisation

should be valued on such factor. Further more, this method mitigates a number of

limitations present in the dividend method. For instance, it is not constrained by

negative values like the dividend method. In addition, the risk that the firm will not

pay dividends in a particular period will not affect the valuation of the free cash flow

method. This scheme is based on free cash flows that always result from trading

companies. The only problem that rests within this method is the elaborate

calculations necessary to determine the figure. As noted in Appendix C a forecast of

future operating profits after taxation, working capital movements and capital

expenditure is necessary. In practice such estimates are very difficult to make

especially in situations when debt ratios change and considerable uncertainty is

present when determining elements like movements in working capital, which

fluctuate considerably (New York University n. d.).