Tesco’s Cost of Equity Analysis

Tesco

Equity Risk Premium

In order to estimate Tesco’s cost of equity, we have utilized the average yield on 10-year UK Gilts for the last 10 years as our risk-free rate, which was 2.3%. Our Equity Risk Premium represents the annualized average weekly premium of the FTSE 100 over the 10Y UK Gilts’ yield computed over the past 10 years (i.e. consistent time-frame as the risk free average), resulting in a 6.1% premium. In particular, the 10Y UK Gilts represents a risk-free rate and its long-term maturity matches the long-term investment horizon of equity investors. The ten-year time-frame suits the valuation time-frame as it covers roughly one economic cycle and is not too far back in time.

Beta

We have selected the three main UK food retailers – Sainsbury's, WM Morrison and M&S – as key comparable companies and have sourced their levered Beta for the last 3 years from Factset on a weekly basis. We believe they operate in the same sector, have similar market risk and country exposures and are therefore relevant comparable companies. Moreover, they all offer online as well as traditional brick and mortar stores across the UK and abroad. The average levered Beta for the peers is ~0.90x, which is below 1.0x and is in line with a consumer staples business which should be less sensitive to changes in the overall market.

With regards to capital structure we obtained market data from Factset. Assuming D = Gross Debt and E = Market Cap, Tesco has a current D / E of 37%, which is slightly above the peers’ average of 29%, therefore we assumed that leverage should converge with the industry peers over the long-term and assumed that Tesco’s target D / E is equal to 29%. Assuming a marginal tax rate of 19% for the three UK peers, we subsequently calculated the unlevered beta as: [ Last 3Y Levered Beta * ( E / V ) + βd * ( D / V )], where we have assumed that βd = 0, as Tesco has a relatively low leverage and its debt is mostly investment grade. The average unlevered beta of the 3 peers is 0.69x, which seems in line with Tesco’s unlevered beta of 0.70x. The unlevered betas are based on the effective blended marginal tax rate based on Tesco’s FY 2018 annual report, which is 19.1%, and a 19.0% marginal corporate tax rate for its peers. We have subsequently releveled the peers’ average unlevered beta assuming Tesco’s target D / E of 29%. The resulting levered beta is therefore equal to 0.90x.

Cost of Equity

The resulting cost of equity (Ke) based on the above assumptions is 7.8%. This is in line with the cost of equity estimate used by sell-side research analysts, including Barclays, HSBC, Societe Generale, whose Cost of Equity’s value we have used as sanity checks.

Cost of Debt

Pre-tax Cost of Debt (Kd) for Tesco is 4.2% and was calculated by dividing Tesco’s finance interest expense for FY 2018 over the FY 2017-2018 average short and long-term interest-bearing liabilities. This equates to a ~190bps spread over the risk free rate, and we have assumed this will also be Tesco’s long-term cost of debt going forward. The post cost of debt would then be 3.4%.