Valuation methods and shareholder value creation

Sainsbury's, the UK's second largest supermarket, controls 16.9% of the market (Sainsbury Annual Reports 2016). The company is involved in grocery and related retention efforts. In terms of profitability, the company has experienced ups and downs for the last 10 years. In 2008, the company had £329 GBP million in net income, which saw a steady growth to up to £716 GBP million in the financial year ending as at 2014. In 2016, the net income was at £377 GBP million and this reveals a decline. This observation is supported by earnings per share and operating margin. Despite the decline in net income, the company has continued to experience growth in terms gross margin (from 5.6% in 2008 to 6.2% in 2016). Additionally, the company has continued to issue shares to potential investors and the number of shares issued has increased from 1,767 million in 2008 to 2,280 million in 2016. These findings indicate that Sainsbury has been experiencing internal growth, which can be ascertained through valuation of its value. For this reason, this report seeks to undertake Sainsbury’s company value to guide a prospective investment firm to undertake proper investment decisions of rebalancing its investment portfolio by replacing the current holding of Tesco with the shares of Sainsbury.


2.0 Valuation methods and analysis


Company valuation helps to set the fair market value of company’s shares and can help in assisting prospective investors to understand how much the company is worth before making their decisions (Evans & Bishop 2001). However, when it comes to valuing a company, the biggest concern is always maximizing its value. The valuation can be undertaken using different types of financial data derived from different sources, such as financial statements and business reports. Thus, there are different valuation methods that can be used to ascertain the value of a company. In this report, there are three different valuation methods that were used in ascertaining the value of Sainsbury’s stock – discounted dividend valuation, residual income valuation, and multiple-based valuation.


2.1 Discounted dividend valuation


The framework for carrying out the discounted dividend valuation is known as the Dividend Discount Model (Pinto, Henry & Robinson 2010). This method is a valuation procedure for valuing stocks of a company using the predicted dividends and discounting these dividends to the present value. In undertaking discounted dividend valuation for Sainsbury, there are several assumptions that are needed to be made. First, dividends are regarded as the relevant cash flows since the investors will receive dividends for their equity in the future. Second, Sainsbury Company pays dividends to its equity investors since the discounted dividend valuation cannot work for companies not paying dividends. These assumptions are derived from the limitations of using discounted dividend valuation method. The most common formula for calculating the value of stock using discounted dividend valuation method is as follows:


(Eqn 1)


Where r = cost of equity, D(1) = predicted next year’s dividend, and g = constant dividend’s growth rate. The formula is based on Gordon Growth Model, which is a common method of discounted dividend valuation.


Cost of equity


The cost of equity is the cost incurred by the company to acquire finances through issuance of shares (Pratt & Grabowski 2010). The cost of equity cannot be ascertained in a straightforward method due to the risks involved in the capital market. In this valuation, CAPM (Capital Asset Pricing Model) will be used to estimate the cost of equity for Sainsbury. In using CAPM, there are several assumptions that are needed to be made (Pahl, 2009). The risk-free rate and equity risk premium is 2.8% and 5.5 % respectively. CAPM formula is as follows:


(Eqn 2)


Where = Risk-free rate (2.8%); = beta or volatility of the company; and = equity risk premium (5.5%)


By definition, beta refers to the sensitivity of the stock’s returns in relation to the market conditions. Sainsbury’s beta is 0.83. Therefore, the cost of equity is calculated using Eqn 2 as follows:


= 7.365%


Predicted next year’s dividend growth


Stock valuation is more challenging than bond valuation because the dividends are not always the same and not guaranteed. In this case, it is essential to make some assumptions that Sainsbury’s future dividends are expected to have a constant growth rate since the company seems to tend to growth in the lifelong at similar rate as the UK economy. According to Finance.Yahoo, the following are the annual dividends per share issued by Sainsbury to its shareholders for the last five years.


Year


Dividend (GBP)


May-12


11.6


May-13


11.9


May-14


8.2


May-15


8.2


May-16


8.1


It can be seen that the dividends are regular and the growth rate is almost zero and thus, it can be assumed that the next year’s dividend will be in the range of £8.1 per share.


Value of Sainsbury’s stock using discounted dividend valuation


With the cost of equity, R and growth rate g, and the expected next year’s dividend, the value of Sainsbury’s stock (the intrinsic value) can be computed as follows:


= £109.98


2.2 Residue income valuation


Residual income is the income the company generates after taking into account the actual cost of capital (Pinto 2015). In this case, the residual income model adjusts the company’s estimates of its future earnings to offset the cost of equity in coming up with a more accurate company’s value. Equity charge, which is the product of company’s total equity and the rate of return, is the key to the calculation of the company’s residual income.


Residual income


Residual income is determined by subtracting equity charge from net income. The first step in determining the residue income is calculating the equity charge as follows:


Cost of capital was earlier calculated using CAPM as 7.365%. According to Sainsbury’s Annual Report (2016), the company has a common stock of £550 million and additional paid-in capital of £1,114 million. The total equity capital is £1664 million. The net income as at 2016 financial year was £471,000,000. Thus, the equity charge can be calculated as:


= £ 122,553,600


Thus, the residue income is follows:


Sainsbury is reporting positive net profit on its income statement and when the cost of equity is included in respect its shareholders’ returns; the company is still economically profitable given the level of exposed risk. Sainsbury is profitable on both accounting and venture basis.


Intrinsic value of stock using residual income


With the residue income computed, it is now possible to calculate the intrinsic value of Sainsbury’s stock for comparison with the market price. The residue valuation discounts residue income as its future cash flows and can use multi-stage approaches, but for the purpose of simplicity, the current residue income will be a future cash flow for the year 2016. The following formula will be used to calculate the intrinsic value of the stock:


(Pinto, 2015) (Eqn 3)


Where = intrinsic value of stock; = book value per share; r = cost of equity and = residue income per share in year 1.


£13.23 per share


= £0.72


Thus, the intrinsic value of Sainsbury’s stock can be calculated as follows:


$13.23 + = £13.64


2.3 Multiple-based valuation


Multiple-based valuation can be regarded as the easiest way of undertaking company valuation and useful for doing comparable company analysis (Risius 2007). This valuation method tries to capture the company’s operating and financial elements (such as expected growth) into a number that need to be multiplied by several financial measures (such as EBITDA) to generate equity value. It is also important to note that these multiples are usually presented as a ratio of capital to financial measures associable with capital providers. Sainsbury will be valued using market valuation multiples, including equity price based multiples and enterprise based multiples.


2.3.1 Equity price based multiples


These multiples are most significant especially where the potential investors are interested in acquiring minority equity in the company. In this category of valuation multiples, Price Earnings (P/E) ratio will be used to value Sainsbury’s stock because the data is highly available. P/E ratio is calculated by the following formula:


Assuming there are no taxes, PE ratio multiple can be defined as a function of unlevered PE ratio, the debt to value ratio, and the cost of debt as follows:


where kd = cost of debt; PE = unlevered PE ratio, D/V = debt to value ratio


Cost of debt


As at Mar. 2016, Sainsbury’s interest expense was GBP 170.94 million. The value of debt is GBP 3785.93 million. Therefore, the cost of debt is calculated as:


Debt to value ratio


The debt to value ratio is the weight of debt which is calculated by dividing debt with the value of capital invested (market capitalization plus debt). Market capitalization was at GBP 6929.67 million. Thus, the debt to value ratio is as:


Thus, PE ratio multiple is as follows:


= 22.15-2.78 = 19.37


2.3.2 Enterprise-based multiples


These multiples complement the valuations done specifically for minority interests (Wessels, et al., 2013). Some of the multiples that are relevant to the valuation of Sainsbury’s stock include Enterprise value/net sales (EV/Sales) and Enterprise value/ EBITDA (EV/EBITDA). Before these multiples are used, it is significant to determine the enterprise value to simplify the calculations.


Enterprise value (EV)


The enterprise value is computed as the market capitalization plus preferred shares and minority interest and debt, minus cash and cash equivalents (Fernández 2002). The company has no preferred stocks and minority interest. As from 2016, the enterprise value was calculated as:


Enterprise value = Market Cap + Long-term debt + current fraction of Long-term debt + capital leases – cash and cash equivalents.


Sainsbury


Enterprise value = £5,525.08 + £2,053 + £137 - £1,242


Enterprise value = £6,473.08 million


EBITDA = £606


= 10.68


= 0.18


Tesco


Enterprise value = £14,750 + £10,623 + £88 - £6,721


Enterprise value = £ 32,182 million


EBITDA = £1,046


= 30.76


= 0.59


3.0 Discussion and conclusions


3.1Discussion


Using discounted dividend valuation method, Sainsbury’s intrinsic value is determined using Gordon Growth Model. The intrinsic value of Sainsbury stock can be compared to the current market value of the share to determine whether the stock is overvalued or undervalued. According to Finance.yahoo.com, the current market price of Sainsbury share is trading at £ 243.00. Clearly, Sainsbury’s stock is overvalued. It can be argued that Sainsbury’s stock current price is not justifiable by its earnings and so the price is anticipated to drop in price, as according to propositions by Lloyd (2013). Such an overvaluation may have been driven by emotional buying, the behavior that inflates the market price of the stock.


The residue income valuation method also provided the intrinsic value of stock. The true value of Sainsbury’s stock using the residue income valuation is £13.64. The current market price of Sainsbury stock is £243.00 and based on this valuation method, the company’s stock is overvalued. The positive side of the residue income valuation method is that it uses readily available data from the general purpose financial reports. Also, the method can be used to evaluate companies that do not pay dividends. However, the residue valuation method depends highly in forward-looking estimates and this leaves a room for psychological biases and emotion reactions.


The enterprise multiples of Sainsbury can be compared to that of Tesco to evaluate whether the company has higher value. The enterprise-based multiples indicate that Sainsbury has lower company value than Tesco. However, the multiple valuations is the most challenging method as the data are not easily obtainable from the company’s financial statements.


3.2 Conclusions


In conclusion, Sainsbury’s stock value is overvalued. The fund manager is advised not to invest in the company since the market stock price can drop in the near future. Additionally, the firm’s value of Sainsbury is lower than that of Tesco Company. The multiple based valuation methods are complex and suffer many limitations since the values can only be compared with another company with similar financial elements. Although discounted divided valuation is simple, it cannot be used for company with no regular dividend payouts. The residue income method is the best method for company valuation since it shows the profitability of the company based on accounting level and venture level. Additionally, the residue method is very simple and holistic as it uses readily available information from the financial statements.


References


Evans, F. C., & Bishop, D. M. (2001). Valuation for M & A: building value in private companies. New York, John Wiley & Sons. http://public.eblib.com/choice/publicfullrecord.aspx?p=130987.


Fernández, P. (2002). Valuation methods and shareholder value creation. San Diego, Calif, Academic Press. http://www.books24x7.com/marc.asp?bookid=5684.


Lloyd, T. K. (2013). Successful stock signals for traders and portfolio managers: integrating technical analysis with fundamentals to improve performance. http://site.ebrary.com/id/10731783.


Pahl, N. (2009). Principles of the Capital Asset Pricing Model and the Importance in Firm Valuation. München, GRIN Verlag GmbH. http://nbn-resolving.de/urn:nbn:de:101:1-2010090222477.


Pinto, J. E. (2015). Equity asset valuation: Jerald E. Pinto ... [et al.]. Hoboken (N.J.), Wiley.


Pinto, J. E., Henry, E., & Robinson, T. R. (2010). Equity Asset Valuation Workbook. Hoboken, John Wiley & Sons. http://www.123library.org/book_details/?id=6778.


Pratt, S. P., & Grabowski, R. J. (2010). Cost of capital: applications and examples. Hoboken, N.J., John Wiley & Sons. http://www.books24x7.com/marc.asp?bookid=40625.


Risius, J. M. (2007). Business valuation: a primer for the legal professional. Chicago, Ill, American Bar Association, Section of Business Law.


Sainsbury. (2016). Annual Reports 2016. Accessed from http://www.annualreports.com/Click/12115


Wessels, D., & Amp, M., Koller, T., & Goedhart, M. (2013). Valuation: measuring and managing the value of companies. Hoboken, N.J., Wiley. http://rbdigital.oneclickdigital.com.


Yahoo Finance. (2016). J Sainsbury plc. Accessed from https://uk.finance.yahoo.com/quote/sbry.l?ltr=1

Deadline is approaching?

Wait no more. Let us write you an essay from scratch

Receive Paper In 3 Hours
Calculate the Price
275 words
First order 15%
Total Price:
$38.07 $38.07
Calculating ellipsis
Hire an expert
This discount is valid only for orders of new customer and with the total more than 25$
This sample could have been used by your fellow student... Get your own unique essay on any topic and submit it by the deadline.

Find Out the Cost of Your Paper

Get Price