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IB114 Financial Management

_________________________ Case-Study: Valuing Tesco shares This exercise attempts to price Tesco shares using only information about dividends per share that can be found in the company’s Annual Reports. We will attempt to obtain a fair (or “fundamental”) value for Tesco shares by calculating the present value of the stream of expected future dividends per share. We will forecast dividends per share five years out into the future. Normally, this would be done by constructing a pro-forma cash-flow forecast with a five-year horizon. However, we will simplify the calculation by assuming that the dividends per share over the next five years will grow at the same rate as the average compound rate of growth over the past five years. In addition, we will assume that dividends per share grow indefinitely thereafter at one-half the rate of the first five years. Tesco shares pay dividends at six-monthly intervals. However, in order to simplify the arithmetic, we will assume that the total dividend is paid once a year. Tesco shares went ex-dividend on 23 April 2008. We need to calculate the present value of the stream of expected future dividends per share that starts exactly one year later:

0

D1

D2

1

2

D4

D3

D6

D5

…

3

4

5

…

6

The ex-dividend (or “xd”) share price P0 is therefore equal to:

P

0



D1 1 R

E



D2 (1  R )2 E



D3 (1 R )3



E

D4 (1  R )4

D5



(1  R ) 5

E



E

D6 (1  R ) 6

 

E

where RE is the company’s (after-tax) cost of equity capital. The cost of equity RE reflects the systematic risk inherent in the stream of expected future dividends per share, and is the correct discount rate to use.

IB114 Financial Management

1. Capital Asset Pricing Model The Capital Asset Pricing Model can be used to estimate the (after-tax) cost of equity RE: R

E

 risk - free rate  (equity beta)  (market risk premium)

The risk-free rate can be approximated by the return on 3-month Treasury bills. [See the FT]. We will assume a value of 6% per annum. [Remember we are pricing the shares on 23 April 2008]. The market risk premium measures how much the return on the stock market is expected to exceed the return on the risk-free asset over the long term. Assume a value of 4% per annum. Tesco’s equity beta can be obtained from e.g. Datastream. Assume a value of 0.9.

Q1. Use the Capital Asset Pricing Model to estimate Tesco’s cost of equity capital RE.

2. Forecasting the dividend per share over a 5-year horizon Analysts typically forecast dividends per share five years out into the future by projecting forward the company’s cash flows. We will do something simpler viz. assume that the dividends per share continue to grow over the next five years at the same rate as they have grown on average over the past five years. Tesco’s dividend (in pence) per share record over the period 2003-2008 is as follows: 2003 6.20

2004 6.84

2005 7.56

2006 8.63

2007 9.64

2008 10.90

Source: Tesco Annual Reports, 2003-2008

Q2a. Calculate the compound average rate of growth of Tesco’s dividend per share over the period 2003-2008. Q2b. Assuming that this compound average rate of growth continues for the next five years, calculate the projected dividend per share for each of the next five years. Q2c. Using the cost of equity capital RE that was obtained in Q1, calculate the present value of the stream of dividends per share that is forecast for the next five years.

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IB114 Financial Management

3. Gordon Growth Model The Gordon Growth Model can be used to calculate the present value P0 of a stream of future dividends per share D1, D2 = D1  (1+G), D3 = D1  (1+G)2, … that grow indefinitely at a constant rate G: P0 

D1 R G E

where, as before, RE is the company’s (after-tax) cost of equity capital. We will use the Gordon Growth Model to calculate the value five years from now of the stream of expected dividends per share that starts with the dividend six years from now.

Q3a. Calculate the projected dividend per share six years from now, assuming that the growth rate from Year 6 onwards is one-half the growth rate of Years 1-5. Q3b. Use the Gordon growth model to calculate the present value of the stream of expected future dividends per share that starts six years from now. [Hint: Remember to discount the answer you obtain back to the present day].

4. Share valuation Q4. Deduce the fair price of Tesco shares on the ex-dividend date, 23 April 2008.

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