benefitsfcf is widely used valuation to estimate

Question

Benefits

FCF is widely used valuation to estimate enterprise value. It measures the value of free cash flow which organisations generate from daily operating activities. DFCF method has a great advantage when valuing enterprise value, by taking time value of money into account as well as the economy environment makes the approach more realistic. In addition, this type of valuation allows synergy to incorporate in the valuation.

Scenarios and Assumptions:

All figures are extracted from London stock exchange website and Sainsbury annual report.

Credit rating			AAA
YTM (Bonds) - KD			5.20%
Tax Rate			32.10%
Beta			72.00%
Debt as % of Capital - WD			27.55%
10-Yr Treasury Bond Yield			3.47%
Market Risk Premium			3.33%
Cost of Equity - KE			5.87%
Equity as % of Capital - WE			72.45%
WACC			5.22%

The revenue growth rate is 5.59% which is calculated from geometric average revenue growth from 2006-2010, due to the overheating market in 2007, and financial crisis in 2008, the figure is turn out to be extreme volatile, but after 2009 the market is showing a good sign of recovery, therefore for the assumption, we believe that Sainsbury might grow faster than our predicted rate.

COGS, administrative expenses and other income are all depend upon the sales figure; therefore we are taking the average percentage those figures dividend by sales.

CAPEX (Capital Expenditure) and depreciation are calculated from average percentage of depreciation and CAPEX divided by NPPE. In this case, NPPE is Net Property, Plant, and Equipment.

NWC (Net Working Capital) is calculated from current asset less current liability, those are simply the ration taken from the financial statement.

Steady-state (SS) growth is 3.47%, which is 10-year UK gilt rate.

There is one thing need to be mentioned in this particular case, there are three columns in the excel sheet which are stated as: Finance income, Finance cost, and Share of post-tax profit/ (loss) from joint ventures. These three figures are both non-operating profit, there are only 3 year tractable data indicated in income statement, this is because Sainsbury started their subsidiary ventures few years ago, therefore these figures are extremely volatile, it is very difficult for us to predict a reliable rate. So average is in used of estimating the rate, we assuming that these figures will grow with constant numbers, which are 52 million, 138 million, and 100 million respectively. In reality, non-operating profit might be increasing over the year; therefore those figures might lead to underestimation.

WACC, Kd and Ke

Credit rating			AAA
YTM (Bonds) - KD			5.20%
Tax Rate			32.10%
Beta			0.72
Debt as % of Capital - WD			27.55%
10-Yr Treasury Bond Yield			3.47%
Market Risk Premium			3.33%
Cost of Equity - KE			5.87%
Equity as % of Capital - WE			72.45%
WACC			5.22%

Credit Rating is mentioned in the Sainsbury annual report, which classified as Aaa by both Moody's, and Standard Poor rating agency.

Kd (cost of debt) is 5.2%, Sainsbury doesn't have long-term bond issued, therefore we using same credit rating firms with in the same industry, to estimate the YTM, in this case Tesco 10-year bond rate is in used. 

Tax rate is the same as the previous table.

Beta is 0.72, which is extracted from Reuters.

Debt ratio is extracted from group balance sheet, which is 27.55% of total asset.

Ke (5.87%) which calculated by using the formula below

k_E = R_f +β_f +β_t x(R_m - R_f)

The market risk premium (2.33%) this is calculated, by using Rm less Rf. Rm is the average Return on Equities (FTSE 100 index average return) from 1985-2010, Rf is the risk free rate (10-year UK gilt).

WACC is calculated by using the formula below:

WACC = E/D+E xk_E +(1-T_C)x D/D+E ×k_D

Hence, EBIT and FCF can be calculated by the formula below:

FCF = EBIT(1-Tc) + Depreciation & Amortization - CAPEX - Increase in NWC

EBIT = Revenue - COGS - SA&G + Other Operating Income

The value of Sainsbury can be calculated by using the following equations:

Terminal Value		7044.204
PV Terminal Value		5598.253
PV FCF (Yr1 to Yr5)		620.1174
Enterprise Value		6218.37
Number of share outstanding		1,871.08
Share price		£       3.32

Sainsbury stand-alone value is worth £ 6218.37 million which equal to £6.21bn, base upon currently share price of Sainsbury £3.48, the valuation shows Sainsbury maybe overvalued by the market. So the price is dropping.

Sainsbury's value with synergy

Because of the synergy effect, Sainsbury' revenue growth will increase to 8.59% for 2012, and next 3 years will increase to 6.59. It predicted COGS/Sales and Administrative/Sales decreases to 93.06% and 2.58% respectively.

			2012	2012-2015
growth rate		5.59%	8.59%	6.59%
COGS/sales		94.00%	93.06%
Growth profit/sales		6.00%
Admin expenses/sales		3.22%	2.58%
other income/sales		0.14%
EBIT		2.91%
Taxes/EBIT		32.10%
Depreciation/sales		6.06%
CAPEX/sales		10.69%
NWC/sales		-5.69%

Terminal Value		37625.17
PV Terminal Value		29901.92
PV FCF (Yr1 to Yr5)		1688.598
Enterprise Value		31590.52
Number of shares outstanding		1,871.08
Share price		£    16.88

The value of Sainsbury after being acquired will increase to £31590.52 (m), which is £31.5bn, new share price of Sainsbury will be £16.88. From the two valuations we have calculated, it shows that acquiring Sainsbury at this stage is not right timing.  Waiting for the market adjust the price, then take it from there, would be rational. However, base upon recent bids for Sainsbury, Qatari Investment Group offered £10.6bn, and private equity groups (CVC, Blackstone and KKR) offered £7.5bn, but both cases had failed due to various reasons, but it showed the value of Sainsbury was quite high, and this is matched to our synergy valuation.

Shortcomings of DFCF

All the calculations are based on our assumptions; the actual scenario can be deviated from assumptions, therefore choosing the right assumption is crucial. Valuation can be over/under valued, also macroeconomics and microeconomics uncertainties, sudden economic events could lead to the failure of valuation.

2. Market multiples valuation

The great advantage of multiples valuation is that very straight forward, very easy to access, don't need compute organisation's intrinsic value, and no need of making assumptions. This action will reduce the uncertainty of future cash flow.

Assumptions and scenarios

Tesco, Morrison, Marks & Spencer , Asda are four main competitors for Sainsbury in the UK retail market, the nature of these firms are similar, but everyone has their own unique selling point in order to enhance their market share.

Equity value multiples valuation

	Tesco	Morrison	Marks & Spencer	industry	Implied Sainsbury Value(m)
Price/Earnings	12.26	12.58	10.95	11.84	8678.72
Price/Sales	0.53	0.47	0.63	0.21	4192.44
Price/Book	1.96	1.45	2.79	0.65	7055.75

Its implied value is calculated from multiplying the average ratio of the three competitors by Sainsbury 2010 sales, earning, and asset. This implied value of Sainsbury is calculated as £6642.30million (£6.64bn)

 Enterprise multiples valuation

	Tesco	Morrison	Marks & Spencer	Average	Implied Sainsbury Value(m)
EV/EBIT	12.80	10.76	38.33	20.63	15123.20
EV/Sales	0.74	0.57	2.97	1.43	28521.06
EV/Asset	0.96	1.03	3.77	1.92	20814.08

For enterprise multiples valuation the implied Sainsbury value is £21486.11m (£21.49bn)

However, even though this type of valuation is fairly straight forward, but compared with other method, it is too simple. The market data of competitors can be unreliable (in this case we all assume that they are correct, Also, picking appropriate comparables are difficult. Different time intervals used will result in different value. When earning or CF figure is negative, the obtained ratio is not valid. In addition, EV multiples are better than equity multiples. All the problems suggest market multiples valuation is preferable to be used as a reference with other valuation method.

By looking at results of two types of valuation, the figures are very similar, £6.21bn is reasonable value for Sainsbury, although it is slightly under the market value, but compared with other competitors, Tesco is too big to acquire, Morrison has relatively small market share, lack of potential of growth. Sainsbury is a rational target. However, the offer for this acquisition should be higher than £6.21bn, from past experience the failed bids were around £7bn-£10bn, therefore our bid can be higher than that to be able to secure the deal, but lower than £15bn to prevent overpaying premium.