## \$TSCO.L – Tesco – a 200p valuation

BLUF: Share price 230p, estimated value 200p, implied downside 13%

In light of Tesco’s announcement to reduce their dividend, I thought it would be worthwhile having a stab at a possible valuation for Tesco. My previous valuation in March (http://wp.me/p2eZvw-Ck) put a value of 360p at a time when the share price was 291p, with an implied upside of 24%.

My new estimate of value, 200p, is a significant reduction from 360p, and pushes the share price from being undervalued to overvalued, despite a reduction in the share price. Such a radical shift should not normally be expected, as it is more usual to make only minor tweaks to the model in the light of new information.

However, the recent announcement by Tesco signals a large downward movement in the overall dividend – a basic input to the valuation model.

It is difficult to decide what the new rebased dividend should be – but that’s what makes the game so interesting. I outline the valuation below.

Let me start off with an earnings estimate. Analysts have an EPS of 23.61p for 2015, and 21.23p for 2016. These will probably need to be reducted, so I will estimate an EPS of 20p. Next, I will apply a dividend cover of 2.46 – which is the highest covering it has had over the last decade. So I am estimating a dividend next year as 8.13p.

Recall our Gordon Dividend Growth Model:
P = D/ (k-G) … 
where
P = stock value
D = expected dividend per share one year from now
k = required rate of return for equity investor
G = growth rate in dividends (in perpetuity)

I am now going to assume that the growth rate in dividends, G, is the risk-free rate. This is a general default assumption. However, you might want to assume that their dividends will never grow, and set G=0.

Sticking with the former assumption, though, gives me a simplification k-G = beta * erp
where
beta is the stock’s beta
erp is the equity risk premium

Using my values from last time, I will set
beta = 0.82
erp = 4.96%

So, plugging those numbers into equation  gives
P = 8.13 /(0.82 * 0.0496) ~= 200p 