Company Valuation:

Woolworths Limited

Zhenglin WU, Joseph LEE, Michelle LEONG & Kaishan CHEN

FINS 2641 – Security Analysis and Valuation

Introduction

The purpose of this report is to undertake a firm valuation for Woolworths, using discounted cash flow model and the relative valuation model.

This report provides information obtained through a conduct of Free Cash Flow to Firm Discount Valuation Model for Woolworths Limited (WOW), estimating the firm’s current share value. The report will then identify 3 key drivers of the firm’s value in this model; tests are performed in the report to identify the sensitivity of share value in the model to changes in specific variables. In the second section of this report, companies, with similar beta and Earnings per Share Growth as Woolworths’, are analysed and compared, using Relative Valuation as another valuation method to estimate the WOW’s current value. Finally, this report will conduct a regression analysis to justify the result achieved in the Relative Valuation.

About Woolworths

Woolworths Limited is the largest food retailer in Australia with principal operations in supermarkets within Australia and in New Zealand. WOW and its main rival, COLES Supermarket, take up around 79% of the total grocery market. WOW also has other operations, which include liquor, petrol, general merchandise and consumer electronics. Woolworths has a market capitalisation of $29,927 million, its shares are currently trading at $24.63 per share. (Market Cap and share price are acquired from FinAnalysis on 16 September 2011)

Discounted Cash Flow Valuation Model (DCF)

Discounted Cash Flow Valuation Model is used to evaluate the potential for investment by discounting back the firm’s future free cash flows. The DCF model used in this report is Free Cash Flow to Equity Valuation Model (FCFE).

Free Cash Flow to Equity (FCFE)

The two-stage FCFE Valuation Model is chosen to estimate the value of Woolworths Limited. The formula is presented as:

FCFE = Net Income – (1 – debt ratio)x[ Capital Expenditure – depreciation + change in non-cash working capital ];

The value of the firm = sum of the present value of each year’s free cash flow to equity + present value of terminal value

P0 = t=n ∑ t =1 [FCFEt / (1 + ke, hg) t] + [FCFEn+1/ (ke, st – gst)]/ (1 + ke, hg) n

- P0 = the firm’s current market value
- ke, hg = cost of equity during high growth period
- ke, st = cost of equity during stable growth period
- gst = stable growth rate

Reasons for the choice of FCFE:

- Based on the information provided in FinAnalysis, the leverage ratio of the firm has been relatively stable over the past 10 financial years.

- In the past 5 years, the dividend paid was significantly lower than the FCFE, Div/FCFE < 80%; or significantly higher than FCFE, Div/FCFE > 1.2

Reasons for the choice of a 2-stage growth model:

A 2-stage growth valuation model is chosen in the report to best demonstrate the growth path of Woolworths. The industry and corporate indicators listed below support our assumption of a 2-stage model:

- Woolworths is a comparatively large firm with market capitalisation of $29,927 million;
- It is growing at a moderate net income growth rate of 11.26%, which is larger than the Australian economy growth rate (1.2%). Also, in order to comply with the condition of using a 2-stage growth valuation model, the NI growth rate should also be less than the economy growth rate + 10%, which is 11.2%; since 11.26% is a proxy, as long as it is significantly close to 11.2%, we believe that 11.26% is a comparable proxy to represent NI growth rate;
- The firm has positive and increasing net profit after tax over the past 10 years; also market expectation says the firm’s market share is increasing due to a rise of 6.5% in the third quarter sales. All information and news available in the market strongly indicate that the firm has the ability to continue operation in the foreseeable future;
- The grocery market has significant barriers for new entrants, as 79% of the market is taken by Woolworths and its rival, Coles.

Also Woolworths and its rival, Coles, have taken up around 79% of the market share, with Woolworths being the largest supplier. Being such a high competitive firm, WOW is able to sustain its core competences, and thus sustain its high growth rate in the next 3 years.

Inputs Analysis

The following inputs are used during the valuation process for FCFE:

Net Income: $2,124 million. This is acquired from WOW’s Balance Sheet in 2011 annual report. The NI will increase by the growth rate each year during the valuation period.

Net Debt Issued: $496.6 million. This is the difference between the New Debt Issued during the financial year, $13,349.2m, and the Debt Repayment during the financial year, $11,590.9m. These two figures are acquired from the Reported Cash Flow on FinAnalysis.

Capital Expenditure: $2,123.2 million. This is acquired from the Reported Cash Flow on FinAnalysis.

Depreciation: $738.1 million. This is acquired from the Reported P&L on FinAnalysis.

Net Capital Expenditure: $1,385.1 million. This is the difference between Capital Expenditure and Depreciation for the financial year ended July 2011.

Change in Non-cash Working Capital: -$8.22 million. Change in Non-cash Working Capital for the financial year ended June 2011 is +$52 million. Presented below is the Non-cash Working Capital (NCWC) for the past 5 years. Since the NCWC has been fluctuated, it is recommended to normalise the NCWC for the valuation. All figures are acquired from FinAnalysis.

Normalised NCWC2011=NCWC2011Revenue2011×Revenue2011-Revenue2010

Debt Ratio: 0.3607. This is calculated as presented, all figures are acquired from FinAnalysis:

δ=Net Debt IssuedNet Capital Expenditure+change in NCWC= $496.6 m$2123.2 m-$738.1 m+(-$8.22 m)

Using the formula presented previously, this estimation of Woolworth’s 2011 FCFE is made:

FCFE= $2,124-1-0.3607×$1,385.1+-$8.22=$1,243.72

The following inputs are used during the valuation process for WOW’s firm value:

Risk free rate: 3.64%. The Australia 3-Year Government Bond yield on 16 September 2011 is used as a proxy for the risk free rate for this valuation. Firstly, Australia has S&P highest credit rating of AAA, also a Fitch credit rating of AA+. These ratings denote expectations of Australia having very low to lowest default risk, very strong to exceptionally strong capacity for payment of financial commitments, where this capacity is not significantly to highly unlikely vulnerable to foreseeable events. Secondly, using Australian-dollar-denoted rate is an easier approach than using USD-denoted rate, where assumptions, for such as exchange rates, may deviate the valuation result from the true value. Thus, we believe that this is a comparable figure to represent the return demanded from a theoretically absolute risk-free investment over this valuation period.

Levered Beta: 0.71 throughout the 3-year high growth period. This is found on FinAnalysis on 16 September 2011. It was calculated by adjusting the industry’s beta based on WOW’s financial leverage. For stable growth period, β=0.8 is chosen, as WOW’s beta will approach to one when the firm is approaching to stable stage, which acknowledges the increased stability of WOW by the end of the high growth period.

Market Risk Premium: 5%. This is acquired from Demodaran Online. It is assumed to be constant over the valuation period.

Cost of Equity: Cost of equity is calculated using the CAPM formula:

ke= rf+β×MRP

Thus,

ke, st=3.64%+0.71×5%=7.19%

ke, hg=3.64%+0.8×5%=7.64%

Growth Rate: different growth rates are estimated for high growth and stable growth period.

For the estimation of high growth rate for each high-growth year, the fundamental is the 2010-2011 net income growth.

g=1-equity reinvestment rate×ROE=1-FCFENet Income×net income2011book value of equity2010=1-$1,243.72 m$2,124 m×$2,124 m$7,817.7 m=11.26%

Where

ROE=net income, 2011book value of equity, 2010=$2,124 m$7817.7 m=27.17%

For stable growth rate, 1.20% is used, based on the assumption that the firm’s growth rate will tend towards the Australian GDP growth rate at the same time as the firm reach steady state.

Using the formula previously presented, the valuation is made:

po=$1,243.72 m×(1+0.1126)(1+0.0719)+$1,243.72 m×1+0.11262(1+0.0719)2+$1,243.72 m×1+0.11263(1+0.0719)3+$1,243.72×1+0.11263×(1+0.012)(0.0764-0.012)×(1+0.0764)3=$27,121.57 million

WOW currently has 1,216 million shares outstanding, thus the estimated value per share is $22.30. The share price of the firm on 16 September 2011 was $24.63. Thus, the firm is currently overvalued.

Sensitivity Test

4 sensitivity tests are undertaken to identify the sensitivity of share price to change in the value of specific assumptions. These sensitivity tests include:

- Price sensitivity to change in number of stages;
- Price sensitivity to change in stable growth rate;
- Price sensitivity to change in cost of equity during stable growth stage;
- Price sensitivity to change in length of high growth stage;

Price sensitivity to change in number of stages: In the scenario, the assumption is changed such that the growth path of WOW would have a transitional stage, and the growth rate would decrease progressively from 11.26% to 1.2%. This could happen when WOW were not able to sustain its core competences due to competitive new entrants and increasing intensity of rivalry. As presented, the estimated share value of WOW will decrease to $20.55, instead of $22.30 initially.

Price sensitivity to change in stable growth rate, 1st key driver of the firm value: One of the key drivers of the firm value is the assumption for the stable growth rate. In our initial valuation, we assume that the firm’s stable growth rate will be approaching to Australian GDP growth rate as the firm achieves stability. As presented, the estimated share value of WOW will increase as the stable growth rate increases.

Price sensitivity to change in cost of equity during stable growth stage, 2nd key driver of the firm value: Another key driver of the value in the process of valuation is the cost of equity during stable growth stage. We initially assumed that the cost of equity will be 7.64% as the beta of the firm will move towards one when the firm approaches stability. The estimated share price of the firm will decrease as the cost of equity during stable growth increases.

Price sensitivity to change in length of high growth, 3rd key driver of the firm value: In the last scenario, the assumption of length of high growth period has changed from the initial 3 years to 5 years. This could happen due to the recent financial breakdown, which would significantly slow down the growth of the firm. Should 5-year high growth be used, Australian 5-Year Government Bond rate of 3.81% is chosen as the risk free rate for the model, as a result of which, the Cost of Equity during high growth and stable growth stages will change as presented below. Other factors stay constant, the estimated share price of WOW will be $26.80, under which circumstances, the firm is undervalued given the current share price is $24.63 on 16 September 2011.

Relative Valuation

Comparable firms are chosen on the basis of valuation fundamentals, whereby consists of firms in different industries within a range of ±50% for both beta and EPS growth.

1. The comparable firms’ EPS growth ranges from of 2.56% to 7.68%.

2. The comparable firms’ beta ranges from 0.355 to 1.065.

Definition Test:

PS ratio is believed to be uniformly measured as all financial figures for the comparable firms are obtained from the current financial year at FinAnalysis. As these comparable firms are from different markets that have different accounting rules, Price to Sales (PS) ratio is chosen as the multiple to evaluate these comparable firms. Besides that, a similar financial leverage across these comparable firms gives us more of the reason to use PS ratio as the multiple.

Descriptive Tests

Presented below is a chart of PS ratio across Australia Market, constructed using the Individual Company Information on Damodaran Online. As presented, the majority of the PS ratios of firms lie between 0 – 3 and over 10. Except firms from mining, metal and biotechnology industries which have PS ratio over 10, most of the firm in the sample have PS ratio from 0 – 3. WOW has a PS ratio of 1.1359, which, we believe, is a comparable figure representing that WOW is correctly valued. Since WOW does not fall into the mining, metal and biotechnology industry, thus it is reasonable to ignore the firms with 10+ PS ratios. As a result, the graph is skewed to the left.

This chart below presents the PS ratios of firms outside the Australian market. The median for US market is 1.36; 0.93 for Europe market; 0.51 for Japan market; 1.74 for emerging markets. As illustrated below, most of the firms in these markets have PS ratio of 0 -3. Similar to other firms outside Australia, WOW has PS ratio of 1.1359, which lies between 0 -3.

Analytical Test for WOW

In the section of the report, we will conduct analytical tests for WOW to identify sensitivity of PS ratio to changes in specific variables.

In this part, we are assuming that WOW is a stable growth firm. The formula of PS ratio for a stable growth firm is:

Price0Sales0= Net Profit Margin ×Payout ratio×(1+g) ke-g

The first chart identifies a positive relationship between PS ratio and growth rate, and a negative relationship between risk free rate and PS ratio. At a certain risk free rate, PS ratio increases at an increasing rate as the expected growth rate increases; and the PS ratio decreases as risk free rate increases, given a certain expected growth rate. Also, it is obvious that a lower risk free rate gives a higher increasing rate.

The second chart describes the relationship between PS ratio, growth rate and net profit margin. As shown in the chart, there is a positive linear relationship between PS ratio and net profit margin, being that PS ratio increases as net profit margin increases. Also, PS ratio increases as the growth rate increases. Moreover, for firms with higher growth rate, their PS ratios tend to increase faster as net profit margin increases.

Application Test:

Regression:

The fundamentals of the Price to Sales suggest the following regression.

PS = a + b1EPS growth + b2Beta + b3Net Profit Margin + b4Payout ratio

The table below shows the fundamental variables (EPS growth, beta, Net Profit Margin, Payout ratio) of the comparable firms to calculate PS ratio for each of them. Financial leverage of the comparable firms is also included to prevent understating the PS ratio for firms that use more debt or less equity.

PS ratio against the fundamental variables is being regressed and the results obtained are as follow:

The regression equation is:

PS = -0.1472 + 118.0405(EPS growth) -10.7058(beta) + 26.9177(Net Profit Margin) +

[5.467] [69.876] [4.535] [8.163]

5.9067(Payout ratio)

[4.561]

To obtain the predicted PS for WOW, substitute EPS growth, beta, Net Profit Margin and Payout ratio into the above equation:

PS = -0.1472 + 118.0405(5.12%) – 10.7058(0.80) + 26.9177(3.83%) + 5.9067(71.10%)

= 2.56

Share Price = PS x Total Revenue / Shares outstanding

= 2.56 x $54,506 / 1,216

= $127.05

As shown above, the PS ratio is primarily driven by the firm’s Net Profit Margin. This is shown by a high t-stat and a low P-value, which explains Net Profit Margin is the most correlated and related fundamental variable to PS ratio compared to the rest. However, it is believed that WOW is relatively undervalued. This is showed by an adjusted R Square of 69.86% which suggested that the fundamental variables do not explain well, and hence lead to an incorrect prediction of the PS ratio and share price. Besides adjusted R Square, there are a few more causes for the unreliable results. First of all, a small sample size and not random samples will lead to a biased result. Next, high P-value and low t-stat for some fundamental variables proves that the result is not accurate. Besides that, standard error is also not considered low. Lastly, we believed that the expected residual value might not equal to zero, which will further lead to an unreliable and inaccurate result.

Differences between discounted cash flow and relative valuation

According to the discounted cash flow model, WOW’s stock price is valued at $22.30 per share. Whereas using the relative valuation of the regression model, the stock is valued at $127.05 per share. We believe that the discounted cash flow model brings out a more sound and true figure, so we shall disregard the share price calculated using the PS ratio due to the following reasons.

- A low R Square of 69.86% implies that there isn’t a strong relationship between the fundamental variables and the PS ratio.
- In our model, we only include 10 comparable firms to compare with WOW. A small sample size implies a higher error as well as a biased result, which makes the outcome unreliable.
- Our regression model has a high P-value and a low t-statistic for most of the variables. This could mean a very inaccurate result.
- Standard error is enormous with a figure of almost 70 for EPS growth, and at least 4 for other variables. These are some discouraging figures to our regression model and meaning a unsound regression equation.
- Finally, the expected residual value might not be equal to zero, which can further lead to an unreliable and inaccurate result.

Final recommendation on the stock to investors

The stock of Woolworth is currently trading at $24.63 per share, and according to our discounted cash flow model, we have estimated the share’s value of $22.30 per share. This is implying that Woolworth’s stock is overvalued in the market at the moment. Therefore, we strongly recommend that investors should invest in Woolworth’s stock because the price is going to increase in the future. For those who are holding WOW’s stock should not try to sell it now, but rather hold on to it for a while and wait for it to appreciate.