Yahoo Finance Calculating The Fair Value Of Tesco PLC (LON:TSCO)
I am going to run you through how I calculated the intrinsic value of Tesco PLC (LON:TSCO) by estimating the company’s future cash flows and discounting them to their present value. I will use the discounted cash flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not June 2018 then I highly recommend you check out the latest calculation for Tesco by following the link below. Check out our latest analysis for Tesco
What’s the value?
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. In the first stage we need to estimate the cash flows to the business over the next five years. Where possible I use analyst estimates, but when these aren’t available I have extrapolated the previous free cash flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past five years, but capped at a reasonable level. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
2018 | 2019 | 2020 | 2021 | 2022 | |
Levered FCF (£, Millions) | £1.04k | £1.49k | £1.69k | £1.74k | £1.69k |
Source | Analyst x11 | Analyst x9 | Analyst x10 | Analyst x7 | Extrapolated @ (-3.09%) |
Present Value Discounted @ 8.28% | £959.05 | £1.27k | £1.33k | £1.26k | £1.13k |
Present Value of 5-year Cash Flow (PVCF)= UK£5.95b
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 1.4%. We discount this to today’s value at a cost of equity of 8.3%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = UK£1.68b × (1 + 1.4%) ÷ (8.3% – 1.4%) = UK£24.82b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = UK£24.82b ÷ ( 1 + 8.3%)5 = UK£16.68b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is UK£22.63b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of £2.33. Compared to the current share price of £2.56, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
Important assumptions
I’d like to point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Tesco as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.3%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company.
For TSCO, I’ve put together three essential factors you should further examine:
Financial Health: Does TSCO have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
Future Earnings: How does TSCO’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of TSCO? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every GB stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.
