Introduction to Tesco

Tesco is a famous retailing company with headquarter located in the United Kingdom. The company has various operations around the world, namely, in the United Kingdom, United States Central Europe, Turkey, China, Malaysia, Japan, South Korea, Thailand and recently, venturing into India. Tesco is a superior company, in terms of customer services, financial performance and growth rate in a competitive business environment (Annual Report, 2010).

Tesco Strategy in the Competitive Marketplace

Since 1997, Tesco had set a long term strategy for the firm. Generally, it is of the corporation objective to broaden the business cope of the company so that the firm can deliver a strong and sustainable growth rate in a competitive market. The scope of business to be focused in is in the retailing and consumer home market, which include areas such as financial services, non-food and telecommunications related products and services. Not only is that, it is also one of the company objectives to expand geographically. Under such a strategy, five elements are outlined. According to the Annual Report 2010 of the firm, the five elements are: (a) to become a successful retailer around the globe, (b) the grow the core business in United Kingdom, (c) to focus and enhance its existing position in food and non-food businesses, (d) to develop competencies in retailing services, and lastly, (e) to put community at the heart of what the company is doing. All of these strategies are consistent with the general commitment and strategic direction of the firm to deliver value to the community while at the similar time protects the environment proactively (Source: Corporate website).

With such a strategic direction to diversify the activities of the firm into related and complementary market segments, the company had able to achieve sustainable growth rate in the recent years. In fact, the achievement of the firm is inspiring and encouraging, as the firm has since then become a widely known market leader in the retailing industry outside the United Kingdom. Not only that, with the decision to expand globally to tap into the larger market share, the firm has also able to derive huge profits from the international context. For instance, the international segment of the firm is only able to generate around 1.8% of the firm profits but currently the international business contribute more than 20% to the firm’s net profit. Both of the main strategic directions set in 1997 enable the firm to grow continuously even taking into account the various financial crises happening in the past ten years. According to the Annual report of the firm in 2010, the firm will continue to pursue such a strategy in the future. By focusing on customers, employees as well as the infrastructure in the retailing businesses of the corporation around the world, the firm is committed to improve shareholders return in the next decades (Annual Report, 2010).

Wealth Creation for Shareholders

A Review of the Share Prices

In the figure below, the stock prices for the company is shown.

Source: Yahoo Finance

In the past five year, it is observed that the stock prices of the company are rising on a pretty constant manner. Although the volatility along the ways are high, the stock prices performance is indeed encouraging and it indicates that the management is doing great job in enhancing shareholders wealth over the past decades. Although the stock prices plummeted during the recent financial crises in 2008, from a long term perspective, the stock performance is satisfactory. It can be safely conclude that the company is creating wealth for the shareholders over the long term, from the stock prices perspective.

A Review of the Financial Performance of Tesco

After reviewing the share prices of Tesco, it is critical for us to review the financial performance of the firm. Several key financial performance indicators will be reviewed, as these indicators can inform us on if the management of Tesco is truly generating wealth for the shareholders. The various important financial indicators over the past decades are shown in Table 1 below.

Table 1: Key Financial Performance Indicators for Tesco.

Source: Adapted from Annual Report

Based on the financial performance, Tesco indeed is a high performing company. For example, the company is able to double the revenue in a period of 10 years. Furthermore, the trend of the revenue is consistent and this indicates the stability of the firm in expanding and growing in a stable manner in the past. Not only that, the shareholders fund of the company is growing at a faster rate. For a 10 years period, the management able to almost triple the shareholders’ fund of Tesco – creating wealth significantly for the shareholders. Purely from the profitability perspective, it is observed that Tesco can be considered as a fast growing company, as it able to growth consistently and steadily over the past decades, a financial achievement not easily achieved by any other companies. The management can be reasonable said to have created wealth for the shareholders. This can be reflected from the long term upward trend of the stock prices as we have discussed in the section before.

Capital Structure

In the following structure, the capital structure of the firm is shown. The capital structure of a business is characterized by its usage of debt relative to the shareholders equity in financing the activities carried out by the firm.

Table 2: Capital Structure related Ratios for Tesco

Source: Adapted from Annual Report

The table above shows that Tesco is engaging in heavier debt leverage throughout the years (i.e., as shown by the ever increasing gearing ratio of the firm). This can be considered as risky for investors, as debt usage can be beneficial to the shareholders in good times while it can threaten even the survival of the firm in recessionary eras, whereby the firm may face issues or problems in servicing the interest payment. The high usage of debt can be a depressing factor towards stock prices. Thus, it is crucial for the management to consider the capital structure properly if the management is to maximize the shareholders’ wealth.

Share Valuation

In the following table, the various investment valuation metrics for Tesco is shown. From the Price to Earnings ratio, it is shown that investors are moderately confident on the prospect of the firm, despite the many uncertainties exists in current economic situation. A P/E ratio of 13.4 shows that investor is neither too optimistic nor too pessimistic on the performance of the company. From the PEG (i.e., P/E divided by the growth rate) perspective, the share is trading at 1.4 times. The price to revenue ratio of the firm is 0.6, a figure below the average market. This is not surprising, as Tesco is generally involved in the thin margin industry, and such a valuation is common in such an industry. Generally, the current market valuation on Tesco indicates that the firm is expected to growth moderately in the long run.

Table 3: Valuation Metrics for Tesco

Source: http://www.digitallook.com/companyresearch/10091/Tesco/company_research.html

Wealth Creation in Tesco

It is shown that Tesco is a high performing company, as the company able to grow in terms of revenue, shareholder funds, and profitability and achieve remarkably high ROE for the shareholders. The strategies employed by the firm are indeed viable and successfully implemented. Generally speaking, the management has been creating wealth for the shareholders, judging from the up-trending stock prices. Nonetheless, the management had been increasingly relying and using debt in running the company as well as to expand the company. This can be a factor depressing the stock prices. Thus, it is possible that the management is not doing a good job in maximizing the shareholders’ wealth if the debt usage is excessive – making the investors thinking that the leverage situation in the firm is risky. This could happen as the debt usage is excessive or exceed the optimal debt to equity ratio; the cost of equity may increases. As the cost of equity increases, the share prices are decreasing. Thus, the shareholder wealth is not maximized. However, to proof that management is not maximizing shareholder wealth is a hard, if not impossible task. This is because without the usage of debt, the company may not grow in such a face pace. As a result, the share prices may not be appealing to growth oriented investors – causing the return from share prices to be reduced. Overall, however, it is safe to conclude that the management is doing a great job in creating shareholder wealth for the company, although they may not be maximizing the shareholders’ wealth with excessive debt usage in the company.

Tesco Dividend Policy

Academic Theories on Dividend Policies

There are generally two methods in which a company can deliver value or reward the shareholders. The first is by growing the company until the investors recognize the attractiveness of the company, and thus bidding up the share prices of the company in the marketplace. In such a way, the shareholders can be rewarded through capital gain. The second method is to distribute dividend to the shareholders.

Dividend policy is often argued by theorist and academicians that it has huge impacts to the share prices. Thus, various theories are available in the many business and finance related textbooks and journals on the relevant dividend policies to be employed by a firm.

Dividend Irrelevance Theory. One of the famous theories on dividend policy is the dividend irrelevance theory proposed by Miller and Modigliani. According to them the dividend has no impact to the stock prices, as the stock prices is primarily determined by the firm’s basic earning power as well as the business risks faced by the firm. The researchers argued that as any shareholders can create their own dividend (out from capital gain), to reward shareholders with dividend or not will not have any impacts towards the stock prices. However, in making such an assertion, both Miller and Modigliani had made unrealistic assumptions. In this theory, it is assumed that taxes and brokerage costs do not exist. This is not true in the real world, making that the dividend irrelevance theory is not valid in the real world (Brigham & Houston, 2004; Wild, 2000).

Bird-in-the-hand Theory. Under this theory, it is argued that a firm’s value can be increased if the management can set a high payout ratio for dividend in the company. It is argued that dividend received is real cash favored by the investors, as the investors have no certainty if the company is really making good profit since they are not the active management of a particular firm. It is argued that investors prefer certainty over uncertainty, and as dividend payment is paid in the form of cash, any high payout ratio indicate that the profitability reflected in the income statement of a firm is true and genuine. Thus, a high payout ratio will enhance the investors’ confidence on the prospect of a firm and thus enhance the share prices of that particular firm. With a higher share prices, the shareholders’ wealth can be created or maximized (Brigham & Houston, 2004).

Tax Preference Theory. This theory explicitly considers the tax impacts to the total return received by the shareholders. If taxes are considered, it is argued to pay lesser dividend is better for wealth creation for shareholders as income tax for dividend payment is generally higher than the taxes applied to capital gain (Brigham & Houston, 2004). Thus, it is rational for the management to prefer lower-taxed capital gain to the higher-taxed dividend income. As such, investors are argued to prefer the company that choose to retain higher earnings in the company (to enhance the growth rate of the company for higher capital gain in the future) in contrast to the case of lower retain earnings in a firm (Brigham & Houston, 2004).

Clientele Effects in Dividend Policy. Under such theory, it is argued that the investors for any stock are some sort of similar minded. Thus, it is important for the management to understand if the investors in the company have preference of capital gain or dividend distribution. If most of the investors in a firm prefer dividend payment, it is important for the firm to continuously pay high dividend to avoid the share prices from plummeting as the investors get scared out from the stock when they perceived any reduction of dividend can indicate that the company is facing some serious troubles (Brigham & Houston, 2004; Wild, 2000).

Dividend Policy of Tesco

Tesco is a firm paying consistently increasing dividend payment for the shareholders. In fact, starting from the year of 2006, Tesco is implementing a new dividend policy in the firm. According to the Annual Report 2006, the management decided to increase the dividend payout broadly in line with its earnings growth rate. The various data concerning Tesco’s dividend policy can be shown in Table 4 below.

Table 4: The Dividend Policy of Tesco

Source: Adapted from Annual Report

As shown in table above, the absolute dividend paid to shareholders are constantly increasing from years to years. This is made possible as the EPS (earning per share) figure of the company is rising steadily from years to years. As the EPS rises steadily, the management has maintained a constant dividend payout ratio. As shown in the table, the dividend payout ratio maintained by the management is around the range of 41%. This indicates that around 41% of the earnings are paid to shareholders as dividend while the rest of the earnings are retained in the firms for reinvestment purposes. Another important observation on the dividend paid out by the firm, as measured in dividend per share basis, by Tesco is that the DPS figure is increasing from years to years. The growth rate of the dividend paid out is similar to the growth rate of the EPS, ranging from 9% to 14%.

A Critical Examination of Tesco’s Dividend Policy

Overall, the dividend policy maintained by the management apparently is beneficial to the stock prices, and hence to the wealth creation process for shareholders. As the firm able to grow in such a steadily pattern, it is good and rationale for the management to maintain such a fix dividend payout ratio for the investors. Firstly, such a dividend policy is easily understood, as investors inherently understand that the dividend rate and amount will be determined by the performance of the firm. The advantages of such dividend policy are that management does not have to constantly revise the dividend policy of the firm to suit the preferences of the investors.

As the firm able to grow in a continuously manner, the constant dividend payout policy ensure that the dividend payment to the investors are rising steadily throughout the years. This will generally enhance the stock prices, because it is perceived by the investment fraternity of that a rising dividend is a strong indication that the firm is stable, growing and performing. The stock prices may be rising due to two reasons. First, the fact that dividend is paid to shareholders – an indication that the profits earned by the company are genuine (i.e., bird in the hand theory). Secondly, even after high payout ratio of the earnings, the firm still able to grow in a relatively fast pace. This indicate that the firm is growing and growth oriented investors may prefer the stock as they believe that future capital gain from the stock is possible since the company EPS is growing steadily over the years. In the language of ‘clientele effects’, the investors of Tesco may consist of both growth oriented investors as well as the income oriented investors. The dividend policy set by the firm will be able to attract both group of investors – and thus bidding up the stock prices. Thus, it is not unreasonable to conclude that the dividend policy set forth by the management is indeed creating wealth for the shareholders.

However, the decision to maintain such a high payout ratio is hardly justified. Firstly, it is observed that the management had engaged in higher and higher debt usage and leverage to grow the company. This is risky in the long term, as debt usage can be a double edged sword. If the company able to reinvest the retained earnings at such a high reinvestment rate (judging from the high ROE and high EPS growth rate achieved by the firm), the firm should not maintain such a high dividend payout rate for investors. In contrast, the earnings should be retained and reinvested to the company. Secondly, excessive usage of debt can be detrimental to the share prices. Thus, if the management can justify that the retained earnings not distributed as dividend is used to reduce the debt usage by the firm, the stock prices as well as the financial health of the firm may be benefited in the long term.

Conclusion

Overall, Tesco is a well performing company. The management is performing a good job in creating wealth for the shareholders. The dividend policy maintained by the firm is also reasonable. It is rational to believe that maintaining constant payout ratio for the firm is beneficial for the stock prices and shareholders’ wealth of the firm, as the firm able to grow steadily on the long term. However, the high usage of debt in the firm is hardly justified. From the financial risk perspective, such a high usage of debt can cause stock prices to get depressed, particularly in the times of financial crises or recession. To grow faster, the company should use less debt, but instead to retain more earnings in the firm. Although the reduction of payout ratio may cause the stock prices to suffer in the short term, the company can be benefited in the long term as the debt burden on the company is relieved.

References

Corporate website: http://www.tescoplc.com/

Annual Report 2010. Tesco Plc.

Brigham, E. F., & Houston, J. F. (2004). Fundamentals of financial management, 10^th edition. International Thomson Publishing.

Cox, R. (1988). Tesco Surges Dramatically Ahead — Is Sainsbury Getting Worried? Retail & Distribution Management, 16(3), 54.

Girod, S. J. G., & Rugman, A. M. (2005). Regional Business Networks and the Multinational Retail Sector. Long Range Planning, 38(4), 335-357.

Jones, D. (2001). Tesco.com: Delivering home shopping. International Commerce Review : ECR Journal, 1(1), 37-43.

Robinson, T. M., & Clarke-Hill, C. M. (1990). Directional Growth by European Retailers. International Journal of Retail & Distribution Management, 18(5), 3.

Weygandt, J., Kiero, D., and Kimmel, P. (1998). Financial Accounting, 3/e, John Wiley.

Wild, J. J. (2000). Financial Accounting-Information for decision, McGraw-Hil.

Save