Discounted Cash Flow Technique
Before computing the price earnings ratio, it is important that we comprehend the meaning of such measurement. The price earnings ratio shows the value of stock in the capital market, in line with increasing return on investment (Randall H. 1999, p 471). Therefore the higher the profitability of the company, the greater the confidence of the market and the higher the price earnings ratio. In this respect, we are expecting a rise in the price earnings ratio, portraying an enhancement in the company’s value in light of the high profitability as indicated by the dividend cover, dividend yield and return on equity, in section 1.
The Price Earnings Ratio of Tesco Plc is determined by utilizing the following investor’s formula: The answer derived from the aforementioned formula is in pounds per share. We can translate it in whole figures to enable comparability and distinction with the other company valuation techniques by multiply it with the number of shares outstanding at that particular date. This is calculated below: This model values a company from the perspective of cash flow. Indeed the free cash flow is an important variable in the equation, which is shown below.
Free cash flow comprises the cash and cash equivalents from operating activities, in which cash and cash equivalents derived from investing operations, are not considered. The equation utilized in order to evaluate Tesco Plc is the following: Source: Pike R. et al 1999, p 104. Where: VO = Valuation of company under free cash flow technique. As we can see in order to ascertain the value of Tesco Plc at a particular year, we ought to determine the cost of equity capital, which is an important variable in the formula provided above.
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Indeed as one can see in the table below, the valuation of Tesco Plc under these methods shows material discrepancies between each. The differences arising from the methods stem from different perspectives that the models adopt. The net asset value approach evaluates the organization from a balance sheet perspective. The problems in this valuation technique stem from the accounting issues that a balance sheet holds. Critics of such system state that measurement of fixed assets at historical cost basis and the deduction of depreciation over the useful life of the asset is inherently deficient.
This is due to the fact that the value of non-current assets shown in the balance sheet will rarely represent the market value of such resources. Historical measurement basis proponents defend on such criticism by stating that corporations periodically review the value of tangible fixed assets, namely freehold land and buildings in order to reflect the market value of theses assets in the financial statements. However in practice a limited number of organizations adopt such evaluations in practice due to the high administrative costs that they normally entail (Pike R. et al 1999, p 94 to 99).
It is also contended that stock and debtors valuation is intrinsically fallacious in the accounts. The excessive prudence adopted by valuing stock at the lower of cost or net realizable value lead to underestimation of stock items. This mainly applies to commodities than recurrently increase in price like fuel. Arguments can also be applied on the inaccuracy of the trade receivables figure under which dubious debtors figures are included in the balance sheet leading to an overstatement of this current asset (Pike R.et al 1999, p 95 to 96).
Another element, which is omitted from the balance sheet and sustains the notion that this method is inaccurate and leads to understatement of the value of the company is the inclusion of intangible assets. For instance the reputation gained by the company from providing good products and associated services is not considered in the balance sheet. The inclusion of such elements will improve the net asset value of the firm.
Executive management in organizations has shown their concern on such issue due to the favorable effect that it will pose on the share price in the capital market. However, under strong-forms of capital markets this will pose no influence since the market would be already knowledgeable of this economic brand value (Pike R. et al 1999, p 97). The utility of the net asset value technique is seriously hindered due to past business combinations, which revealed that the value of the company portrayed in the purchase consideration was much higher than the net asset value.
For example, the acquisition in 1988 of the United Kingdom chocolate producer Rowntree by Nestle or the Swiss Confectionery showed that the company valuation offered by these firms was much higher than the net assets valued computed in the financial statements of the company (Pike R. et al 1999, p 97). In fact, due to such limitations the role of the net asset value model is limited only to set a guide for the lower limit of the organization’s value of equity (Pike R. et al 1999, p 99).