However, this trend is in some way or another contradicts the traditional theory about the consistency of the gearing ratio (leverage ratio) and EPS. It is commonly accepted that the increase of the gearing ratio will significantly couple with the increasing trend of EPS, and vice versa (Rolf, 1981). In Tesco’s case, the decline of gearing ratio parallels the incline of earnings per share. This shows that rather than raising more debt to finance capital expenses and operating costs, Tesco uses other methods (such as ploughing substantial proportion of its profits back to its businesses) to maintain its strong growth momentum.
Thirdly, return on capital employed ratio (ROCE) increased from 10.8% to 12.7%, or by 18%. This is an efficiency ratio of the performance of management. Virtually, the company has increase the utility of the capital employed in its businesses.
Fourthly, the interest cover also increased from 8.64 to 12.39, or 43.4% during the last five years. It shows the strengthened ability to pay interest, due to the significant increase of operating profits these years. And incontestably, this good news is inconsistent with the increase of the gross profit margin mentioned before.
Last but not least, for international companies like Tesco, the rule of thumb is that a debt/equity ratio (also known as leverage ratio or gearing ratio) of less than 100 per cent is reasonable. But the most appropriate gearing ratio is dependent on more external and internal variables. According to the mainstream theories that companies with a strong ability to generate cash flow can safely hold a higher level of debt and thus they will tempt to raise more debt (Olivier, 1993). However, this is contradicted by Tesco’s case in which the international retailer tempted to lower its gearing ratio while keeping an increasing amount of operating profits.
So, there is a fundamental question to be answered: what’s the appropriate mix of debt and equity? Is the mix of debt and equity optimal on Tesco’s balance sheet? In order to answer the questions above, it is better to analyze more specifically the capital structure of Tesco reflected by its balance sheets.
Tesco’s Capital Structure
As mentioned above, some traditional theories focus on the positive relationship between the leverage ratio and earnings per share, however, the situation of Tesco is the reverse version. When the historical leverage ratio decreased, the earning per share climbed to a historic new high in 2006, or even higher in 2007 (from the semi-annual report of Tesco).
The mix of equity and debt is primarily related to financial leverage, namely long-term liabilities, which have significant influence on other financial indices such as earnings on earnings per share (EPS), return on capital employed (ROCE), return on investment (ROI), dividend per share (DPS), weighted average cost of capital (WACC), cost of equity and cost of debt (William and Jorion, 1993).
Among all this indicators, the weighted average cost of capital (commonly known as WACC) is used to measure the total cost of capital of a business, including equity and debt. Actually this indicator has been utilized by many businesses as a discount rate to calculate and estimate the net present value (NPV) of a financed project. Weighted average cost of capital is also referred to as the return a company must earn from its assets to keep its sustainability and constant development (by paying the tax, interest, and satisfying its creditors and owners). In effect, the indicator WACC allows for the relative weights of each element within the capital structure (debt and equity).
Notes: Ke = the cost of equity capital, KL = Cost of loan capital, Ve = Current market value of all equity capital, VL =Current market value of all debt
During the early development of the capital structure theories, many scholars focus on that an optimal capital structure can be achieved when the WACC is minimal. However, this theory has run into many skeptics due to its strict assumptions: no reserved earnings, no taxes, etc. Those assumptions began to be released from 1958, when Franco Modigliani and Merton Miller put forward their theory of capital structure. Also, in 1963, tax factor is introduced into the capital structure model as a tax shield and a business can gain benefits by raising more debt rather than using its equity to reduce the tax payment. Under this circumstance, the value of a firm can be calculated as:
Further, other theories tried to break more limitations of the assumptions; they allowed for more influential factors which can affect the cost of assets and further the capital structure, such as agency costs, bankruptcy costs, financial distress costs, etc.
In this report, we use the revised MM model and the WACC model to calculate the value of Tesco Group as an attempt to determine the optimal capital structure of the company. The cost of equity capital, cost of loan capital, current market value of all equity capital, current market value of all debt of Tesco and the WACC value are calculated by SPSS in figure 2 and table 3.
Figure 2 and table 3: calculation of WACC by SPSS
Notes: Cost of debt = R interest × (1 – R tax), and R tax is the average of the benchmark tax rate of UK for the last five years, which is 0.34. Cost of equity = (Dividend / Net worth) x 100% or Cost of equity = (Shareholders’ Capital / Net Assets) x 100%.
After calculating the cost the capital of Tesco Group for the last five years, what we have to do is to calculate the value of the company based on the calculation of WACC, and the results are as follows:
Table 4 calculation of the value Tesco based on the model of WACC
Notes: EBIT = earnings before interest and tax.
From table 4, to some extent, the calculation results are consistent with what we have learnt from some traditional theories: an optimal capital structure can be achieved when the WACC is minimal. Nonetheless, we cannot conclude that the lower the level of WACC, the higher value of Tesco will be. For the same token, we cannot conclude that the lower the gearing ratio (or leverage level) the higher value of Tesco will be; although the gearing ratio decreased dramatically for these five years.
What we can conclude is that, the change of the mix of equity and debt of Tesco these years indeed reduced the level of WACC and significantly added to the value of Tesco. Namely, the company approached its better capital structure.
Tesco’s Dividend Policy
In this part of our report, we come to the dividend policy of Tesco Group. The dividend policy is in effect linked to the interest of the investors. Good and divined policy can attract more investors and for analogy; poor divined policy can lost investors and consequently affect the market value and share prices of the company.
We look at three schools of theory on dividend policy. The dividend irrelevance school suggests that dividend policy does not matter as expected, due to its faint linkage to the firm value. That is, if a firm's investment policy (and hence cash flows) doesn't change, the value of the firm cannot change with dividend policy. This thought has two assumptions: an investor does not have to pay tax when receiving dividends and if a firm pays too much in cash, it can issue new stock, with no flotation costs or signaling consequences, to replace this cash.
The second school suggests that dividend policy is bad for the average stockholders because they have to pay tax when receiving dividends. However, in opposition to the second school, the third group argues that if stockholders like dividends, or dividends operate as a signal of future prospects, dividends are good for stockholders and can boost the value of the firm (Hyderabad, 1997).
Back to Tesco’s case, it is primary to test the relationship between the value of the firm and the dividends of firm for the last five years, namely from 2002 to 2006. We use EXCEL to calculate the covariance between firm value and dividends, variance of firm value and variance of dividends. The equation is expressed as follow:
Figure 5 calculation of correlation between firm value and value
From figure 5, the Tesco’s value and its dividends are highly correlated, marked with a coefficient 0.987. This result strong supports that third school of theory on dividend policy: if stockholders like dividends, or dividends operate as a signal of future prospects, dividends are good for stockholders and can boost the value of the firm.
Evidently, the increase in dividends does have a substantial positive impact on the firm value of Tesco for the past five years.
In addition, in order to analyze the dividend policy of Tesco more specifically, we introduce another technical method into our analysis – time series estimation of the change of earnings per share and dividend per share. By definition, time series estimation is the use of a model to estimate future events based on known past data: to estimate future data points before they can be measured. The typical example is the opening price of a share of stock based on its past performance.
In this report, we use the statistical software EVIEW to estimate earnings per share and dividend per share of Tesco in 2008 and 2009. The estimation method is auto-regressional estimation. The results of the estimation are shown in table 6, figure 7 and figure 8.
Table 6 Time series estimation of Earnings per Share and Dividend per Share of Tesco in 2008 and 2009 by EVIEW
Figure 7 and figure 8: time series estimation of EPS and DPS of Tesco
Notes: EPS = earnings per share, EEPS = estimated earnings per share, DPS = dividends per share, EDPS = estimated dividends per share.
For last five years, the dividend policy of Tesco attempted to increase the distribution volume, which was coupled with the growth of earnings per share (table 6). Earnings per share increased from 12.05p to 22.36, or by 12%, 11%, 18%, 14% and 11% respectively. Dividends increased from 5.6p to 9.64p, or by 11%, 10%, 11%, 14 % and 12% respectively. In the future, says 2008 or 2009, earnings per share will increase to 24.54p and 26.58p, or by 10.5% and 8.3%; dividend per share will increase to 10.4p and 11.18p, or by 9.4% and 10.8%, which are smaller than the historical growth rate.
The future trend of dividend shows that the increase of dividends will slow down in 2008 and 2009, which is consistent with the attempt of Tesco to lower the gearing ratio and use a great amount of its earnings to finance its businesses. As investor, we do not need to worry about the future slowing down of increase of dividends may reflect some negative signs; instead many leading firms like Tesco endeavor to use a stable and smooth dividend policy, because of the increasing risks of long-term debt .
Security valuation of Tesco
- Stock price trend of Tesco
The stock price of Tesco has grown considerably from 170p in 2003 to more than 450p in the end of 2007. On average, the company secured a 10.5% of yearly growth rate from 2003 to 2007 (figure 9). This shows a golden buying opportunity for the investors since the stock value can increase at any time despite some slight reversion from time to time. Take 2007 as an example (figure 10), the price started at 415p in Jan and began to climb. After reaching the climax 470p in May, the price dropped to lower than 400 until Aug, and then resumed the incline momentum and reached a historic new high in Oct Nov. After that, the share price began to fluctuate in a small scale until the precipitous decline in late Dec. The price at that time even dropped to below 420p.
Figure 9 the stock price change of Tesco for the past five years
(http://www.lse.co.uk/ShareChart.asp?sharechart=TSCO&share=tesco)
Figure 10 the stock price change of Tesco in 2007
(http://www.lse.co.uk/ShareChart.asp?sharechart=TSCO&share=tesco)
Based on the historical data of these years, although the recent regression of the share price of Tesco may be a negative signal for investors and its shareholders, the increasing trend of Tesco is still on its way, which is supported by the great profitability of the company. The business fundamental of the company is still inherently strong. Thus when we buy the stock at its lower price range, we will greatly benefit from the sustained rise due to the future recovery of the market and that there is by no means that we should worry whether the share price of the company will decline in paper value again.
In addition, Tesco has the capacity to retain its continuous profit margins and the smoothly increasing annual dividends which investors can gain will in no doubt overshadow potential risks and market uncertainties.
- The technical analysis of Tesco’s share price
After analyzing the long-term trend and short-term trend of the share price of Tesco, we come to more technical analysis method to determine whether we deserve to invest in the company’s stock.
The most popular model to determine the share price is as follow:
Where, DPSt = Expected dividends per share, Ke = Cost of equity.
The rationale for this model is based on the present value model – the value of any asset is the aggregate of present value of expected future cash flows which are discounted at a rate appropriate according to the opportunity costs of the cash flows (Stephen and Cummins, 2000).
In fact, this model is flexible enough to allow for different discount rates at different times, where the difference is caused by expected changes in interest rates or risk across time. To simplify the model, we introduce the Gordon growth model to value a firm which is in constant growing state with dividends also growing at a constant rate that can be regularly forecasted (Stephen and Cummins, 2000).
The Gordon growth model greatly simplifies the valuation model which includes the expected dividends of the stock in the next time period, the cost of equity and the expected growth rate in dividends.
where DPS = Expected dividends in the next time period, Ke = Costs of equity, and g = Growth rate in dividends which is expected to remain invariable.
There are three components to determine, DPS, Ke and g. First, if the company wants to grow, it has to plough excessive earnings back to its businesses; this means its growth will be supported by the return on equity minus the dividend to paid to its shareholders. So,
Table 11 calculation of growth rate of Tesco
Next, to calculate Costs of equity, we introduce the CAPM model. The Capital Asset Pricing Model (CAPM) is used to determine an appropriate required rate of return (otherwise known as costs of equity), if the asset is to be added to a diverse portfolio of assets. The CAPM model takes into consideration an asset's sensitivity to market risk (otherwise known as systematic risk), often denoted by the variable beta (β), the expected return of the market and the expected return of a non-risk assets (John and Lucas, 1999).
Figure 12 Calculation of Covariance (RTesco, Rm) and Variance (Rm) by EXCEL
We use EXCEL to Calculate the Covariance (RTesco, Rm), Variance (Rm) of the CAPM model, and the βvalue. The results are as follows:
Here the R f is commonly perceived as the annual interest rate, 5.4%. R market is perceived as the rate of market return. We use EXCEL to calculate the yearly market return (sample: FTSE index from 2002 to 2006), and R market = 0.804. ().
And consequently, using the average growth rate of Tesco from 2002 to 2006, calculated as 0.0837, and the estimated dividend per share in 2007, calculated as 9.67 (table 6), the estimated share price of Tesco is:
The estimated share price of Tesco seems reasonable because the fluctuation of Tesco’s share price was visibly around the line 443.99p (figure 13). Obviously, it is hard to say whether the share price is underestimated or overestimated; in reality, the market price approaches the real price.
Figure 13 the share price fluctuates around 443.99p in 2007
(http://www.lse.co.uk/ShareChart.asp?sharechart=TSCO&share=tesco)
In conclusion, in the short term, it may be sensible to invest in if the market price of the stock drops well below its estimated price 443.99p because the recovery of the market will generate great revenue; it may be not reasonable to buy the stock if the market price is higher than the estimated line; when the market price is rather near the estimated value, it is better for the investor to adopt wait-and-see strategy.
In the long-term, the investment in Tesco’s stock must be worthwhile.
- From the analysis above, we have already got a full picture of the financial management practices and policies of Tesco.
- Form the time series estimation; we know that the company will continue to distribute more of its earnings to its shareholders.
- From the correlation analysis, we know that there is strong link between the firm value and its dividend policy, which means the moderate dividend policy of Tesco will incontestably add to the value of the firm.
- From the gearing ratio and EPS analysis, we know that the company’s financial strategy is not consistent with some traditional theory, featuring the negative relationship between the leverage level and earnings per share.
- Tesco’s unique dividend and distribution policy has enabled it to secure a fast growth rate without raising more risky debt.
- We also use the CAPM model and constant model to estimate the share price in 2007 and find out that, the estimation result is surprisingly consistent with the fluctuation of the share price of Tesco in late 2007.
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