Valuation on Woolworths Limited

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Comparison

The beta derived here is slightly different from those published by other institutions such as Morningstar. Morningstar gives a beta of 0.67 for the company (Morningstar 2015). There are several factors contributing to this difference and discussed in turn as follow.

First of all, the frequency of calculation will affect the outcome. Same as this report, Morningstar also adopts the monthly interval to collect data. But it’s noticed that Morningstar recalculates the beta every quarter while the beta in this report is simply calculated once using the past five years’ data.

Secondly, different time periods have been chose. The published data is based on a rolling 48-month time series, which is over 4-year time. In this report, however, the time frame chose is over 5-year time from 1 May 2010 to 1 May 2015. Although it’s just a one year difference, with the monthly interval, the sample here in fact involves 12 more data in it, which may be quite enough to cause the slight difference in the estimation of beta.

Furthermore, the choice of calculation methods also amounts to the difference. According to Morningstar (2007), a regression model is run to calculate the industry average beta, from which a company beta is derived by adjusting it based on the company’s financial leverage. It’s argued that using the industry-adjusted beta is more likely to reflect true operating risk since the leverage structure change in the period tend to render the raw regression beta of company less effective (Koller, Goedhart, and Wessels 2010). In this report the latter method is adopted and thereby amounts to the difference.

Last but not least, the calculation of beta allows a choice of risk-free rate and risk premium. Unlike in this report where the return on 10-year government bond and AORD are applied respectively as risk-free rate and market rate, 5-year government bond or ASX 200 may be chose for getting the published beta. As this leads to different results of risk premium and excess returns, the outcome of beta will also be affected.

3. Determining an appropriate discount rate

Calculation

The equation for CAPM model is as below.

[pic 14]

Where return on asset (discount rate), [pic 15]

market risk premium[pic 16]

With 0.4467,[pic 17][pic 18]

[pic 19]

The detailed working for, ( and can be seen in the appendix. [pic 20][pic 21][pic 22]

Justification of Assumptions

It’s assumed that the 20-year average of the return on 10 year government bond is the risk-free rate. To reach a reliable risk-free rate, with the 10 year government bond chosen, it’s not appropriate to use the most recent number of return on the government bond. This is because unusual and volatile conditions in bond markets have led it to historically low and thus it is not a good proxy for reflecting a fairly reliable risk-free rate (Blake, Fallon and Zolotic 2012). Alternatively, the 20-year average numbers of yearly risk free rate is calculated here, using the data sourced from Reserve Bank of Australia (2015).

To be consistent, it’s assumed that the 20-year average of the excess returns on the AORD represents the market risk premium in this calculation, with data sourced from Bloomberg (2015). Studies also show that although a shorter time period may provide a more updated estimate if risk premium, this advantage has to be offset against the costs of greater noise in the risk premium estimate. Hence, to get reasonable standard errors, a very long time period of historical return, usually 10-20 years, is needed (Damodaran 2008). Calculated in this way, the risk premium here is about 5.95%, which is just slightly different from the estimate of 6% that is widely used in practice (Value Adviser Associates 2008).

It’s also assumed that the beta applied to the equation is the same as the number derived from question 2, which is 0.4467. This number is also assumed to be fairly reasonable since it’s close to those numbers given by other institutions.

What’s more, when applying the CAPM model, it’s assumed that all investors can borrow or lend at the same risk-free rate.

4. Inferring the growth rate

Calculation

The dividend discount model is given as follow,

[pic 23]

The current price of share[pic 24]

Forecast dividend at the end of first year [pic 25]

= cost of equity [pic 26]

= constant dividend growth rate [pic 27]

Since the company pays dividends semi-annually and here is the interim dividend paid on 24 April 2015, it’s required to convert the annual discount rate of to the semi-annual discount rate using the following formula. [pic 28][pic 29]

[pic 30]

With, [pic 31][pic 32]

Rearranging the dividend discount model gives us an equation as follow.

[pic 33]

With 28.48,,0.0400,[pic 34][pic 35][pic 36]

[pic 37]

Note that this is the semi-annual dividend growth rate. To reach an annual growth rate, the following equation is applied.

[pic 38]

With, [pic 39][pic 40]

(Dividend data is sourced from Morningstar (2015b) and the current market price is sourced from Yahoo Finance (2015b).)

Analysis

Based on the historical growth rate

Woolworths Limited is known as one of those companies that are more reliable than others when it comes to maintaining dividends, in other words, it has a relatively higher dividend stability (Financial Review 2013). Therefore it’s reasonable to analyze the estimated dividend growth rate referring to the historical data.

According