Tesco - further detail

I thought I would post some extra information on the motivation for my purchase of Tesco shares.

Return on equity
The interesting thing about return on equity, or RoE, is as a multiplier on reinvested earnings. If company A earns £100, reinvests it at a RoE of 10%, it could expect (ceteris paribus) to earn £110 the following year. If company B also earns £100 but reinvests it at a RoE of 20%, it could expect to earn £120 the following year. At low rates of RoE, reinvestment becomes uneconomic and the company should logically pay all its earnings out as dividends.

Calculating RoE first requires a reliable figure for earnings. To avoid tax clouding the picture, I assumed tax of 30% and calculated earnings as (Operating Profit - Interest payments) * 0.7.

Inflation clouds the RoE picture by silently increasing the value of assets. The equity figure quoted by the company is therefore too low. To account for this I assumed 3% inflation of Tesco's equity per year from the start of my 14 year period.

With these adjustments, Tesco's RoE figure is remarkably consistent at between 11.5% and 13.5%. It averages 12.2%.

Consistent earnings growth
Tesco's turnover has increased by an average of 13% per year. In only one year out of 14 was it less than 8%. Margin (operating profit divided by turnover) has been consistently between 5 and 6%, averaging 5.6%.

Of course Tesco has operated in a benign retail climate over the last 14 years, but I think we can assume that it will at least weather the storm, if not continue with quite the same stupendous growth record.

Having said that, turnover has tracked inflation-adjusted equity remarkably closely. It has been between 3 and 3.75 times equity every year, averaging 3.29.

Conservative capital structure
For a company pursuing such an extraordinary growth path, Tesco has remained very lightly geared. With such amazingly consistent profitability, it would not be unreasonably for Tesco to gear up to the point of pre-tax earnings covering interest by, say, 3 times. At 6% yield that would suggest a sustainable net debt of £16bn. In fact they operate with only £8bn of debt, offset by £2bn of cash to leave only £6bn net debt.

This extremely conservative capital structure gives Tesco shares a level of security that is rare in today's highly geared market.

Annual return
Tesco pays a dividend of 3.1% on their current share price of 320p. They reinvest a further 5%, generating 7.7% earnings growth (based on RoE of 12.2%). Their earnings increase with inflation, adding 3%. This leaves Tesco generating a total shareholder return of about 13.8%, or 10.8% in real terms.

Numbers schmumbers
Of course, all of this is really just a mathematical parlour game. There is no guarantee that these numbers will hold in the future. On the other hand, I think they're as good a base as any. They've held true very consistently for 14 years. And a return of almost 14% leaves a good margin of safety.

Their tangible assets were about £20bn in February '08 (using their estimate of the value of their property rather than the lower book value). That will have suffered due to lower appetite for commercial property, but even so it leaves a comparatively small valuation in their £25bn market cap for their superb brand.

Downsides
Tesco faces a number of risks. Competition concerns are likely to stifle UK growth to some extent. A prolonged recession would lead to reduced margins and probably a loss of market share. Their global growth is meeting competition from Wal-Mart and others.

The risk with extrapolating from past trends is that you double-count. A fall in Tesco's margins will lead to a corresponding fall in their RoE, their earnings, and their potential for growth. A fall in margin to 3% would leave them with a P/E ratio of 24 and comparatively poor growth prospects. With no growth prospects a P/E ratio of 8 might be more appropriate, and in one fell swoop the shares would lose two thirds of their value.

Conclusion
Clearly, since I just bought a bunch of shares, I'm optimistic. I think Tesco have proved their growth credentials, and I have high hopes for Tesco Personal Finance taking market share from the discredited big banks. Their future growth might not come from ever more UK stores, but it doesn't need to.