Reference no: EM132880613

Valuation Project: Target

Background

Target Corp., established as the discount division of the Dayton's Company of Minneapolis, MN in 1962, is the second-largest discount retailer in the United States. As of 2021, the company operates 1,897 stores across the US. Since April 2020, the company's share price has outperformed the S&P 500 by 55%, thanks to its strong sales and earnings growth during the pandemic period. For example, the company has beaten analyst consensus sales and earnings estimates four quarters in a row since the first quarter of 2020. In particular, Target's e-commerce sales growth has outperformed other retail peers such as Walmart and Home Depot, and its own delivery service, Shipt, and pickup services are getting traction.

Perhaps not surprising given these positives, the majority of the analysts recommend that the company's equity will outperform the market. 1 However, continued investment in the company's e-commerce infrastructure, refurbishing stores, and labor could put pressure on its operating margins going forward. Also, it is not clear whether the benefits Target has enjoyed during the pandemic would last in the medium to long run. Therefore, Target's equity poses both potential challenges and opportunities to analysts and investors: On the one hand, the recent outperformance relative to the overall market as well as the retail peers might indicate that the company's equity now fully reflects its fundamentals or is even potentially overvalued. On the other hand, Target's equity may still offer an attractive investment opportunity, if the company's future outlook for generating free cash flows and growth, given the risk, more than justify the current valuation. Therefore, the conclusion as to whether Target is an attractive investment should depend on your careful valuation analysis that incorporates its fundamental cash flow generating abilities and prices of the company as well as other comparable companies.

1. [Relative Valuation using Multiples] Estimate the (1) total equity value and (2) per-share equity value of Target using relative valuation approaches. Follow the instructions below

(1) Come up with an initial set of potentially comparable firms for Target. Please begin with a group of firms in the same or similar industries from Capital IQ (‘Peer Analysis'-‘Quick Comps') or FactSet (‘Company/Security'-‘Overviews'-‘Comps'). Optional: You can add and/or remove some companies to/from the set, if you'd like. In that case, please explain your justification (e.g., exclude non-US firms, which might have different valuations).

(2) Construct your own price-to-sales (P/S) multiples as ratios between the market value of equity and fiscal year 20212 consensus forecasted sales (S) for this initial set of comparable firms, as well as Target.3 Please do not simply use "off-the-shelf" values of the multiple from standard data sources (such as Capital IQ), which are often based on historical fundamentals.
Hint: Market value of equity is current (i.e., today's) market capitalization.

(3) For the initial set of comparable firms and Target, collect information on the following key value drivers and their proxies for P/S, and show it in a table :
a. Growth rate of net income (or even sales) from fiscal 2021 and onward (such as into 2022/2023)
b. Net income margins = net income/sales
c. Costs of capital (equity beta can be a good proxy)
d. Firm size (proxied by, e.g., revenue, market cap)

(4) Using the key value drivers and proxies you collected above as much as possible, narrow down the initial comparable set to a final set of comparable firms for the purpose of P/S multiples valuation.

Hint: Using all firms in the same or similar industry, or choosing comparable firms based only on qualitative characteristics (e.g., geographic location, business models) will not suffice.

(5) Compute the implied total equity value of Target. Specifically, multiply its fiscal 2021 forecasted sales by a "typical" (e.g., mean, median) P/S multiple for the set of comparable firms you choose in part 4). Then, compute the implied per-share equity values of Target by scaling the implied equity value by the number of shares outstanding.

2. [Preparing Historical Data for DCF Valuation] In this question, we will compile historical financial statements for Target in preparation for valuing the company using a discounted cash flows (DCF) approach (which you will do in Part II of the project). The goal of this question is to compute historical free cash flows to the firm (FCFF) and other key line items of Target's over the past five years using the income statement, balance sheet, and statement of cash flows collected from available data sources (such as 10-Ks from the SEC EDGAR, Capital IQ, FactSet).4 Follow the instructions below:
(1) From fiscal years 2016 to 2020, compute/show each of the following line items:
o Net operating profits after taxes (NOPAT)
» Sales revenue
» Cost of goods sold (COGS)
» Selling, general, and administrative (SG&A) expenses
» Depreciation and amortization
» Estimated effective tax rate for NOPAT
o Current operating assets = sum of the following items:
» Operating cash (you can assume 2% of revenue, if you'd like)
» Accounts receivables & Other receivables
» Inventory
» Prepaid expenses
» Other current assets
o Current operating liabilities = sum of the following items:
» Accounts payables
» Accrued expenses
» Current income taxes payable
» Unearned revenues, current
» Other current liabilities
o Invested capital (IC) = Net PP&E + NOWC
» Net property, plant, and equipment (PP&E)
» Net operating working capital (NOWC) = Current operating assets (OCA) - current operating liabilities (OCL)
o Capital expenditures (CAPEX)
o Free cash flows to the firm (FCFF) = NOPAT - (CAPEX - Depreciation + ?NOWC)
(2) From fiscal years 2016 to 2020, compute the ratio of each of the above line items to revenue (except for effective tax rates).

(3) From fiscal years 2017 to 2020, compute return on invested capital (ROIC), defined as "NOPAT / previous year's IC" using IC computed above.

3. [Projecting Free Cash Flows Using a Sales-driven Approach to DCF Valuation] Project Target's free cash flows to the firm (FCFF) over the next five years (that is, from fiscal years 2021 to 2025) using sales revenue as a basis for projection. Follow the instructions below:
(1) From 2021 to 2025, project sales revenues. Fully justify your forecasts of sales growth rates.

(2) From 2021 to 2025, project the following income statement items as ratios to sales revenue. The ultimate goal here is to project net operating profits after taxes (NOPAT). Fully explain and justify your projection of each of the ratios:
o Cost of goods sold (COGS)
o Selling, general, and administrative (SG&A) expenses
o Depreciation and amortization
o Operating profits
o Net operating profits after taxes (NOPAT)
» In addition, explain how you estimated effective tax rates for NOPAT.

(3) From 2021 to 2025, project the following balance sheet items as ratios to sales revenue. The ultimate goal here is to project invested capital (IC). If you think it is sensible, you can choose to combine some line items in your projection (e.g., items that are of a tiny fraction of sales).5 Fully explain and justify your projection of each of the ratios:
o Current operating assets: sum of the following items
» Operating cash (you can assume 2% of revenue, if you'd like)
» Accounts receivables & Other receivables
» Inventory
» Prepaid expenses
» Other current assets
o Current operating liabilities: sum of the following items
» Accounts payables
» Accrued expenses
» Current income taxes payable
» Unearned revenues, current
» Other current liabilities
o Invested capital (IC) = Net PP&E + NOWC.
» Net property, plant, and equipment (Net PP&E)
» Net operating working capital (NOWC)

(4) From 2021 to 2025, compute return on invested capital (ROIC), defined as ‘NOPAT / previous year's IC.' Comment on projected values of ROIC. In particular:
o How do they compare with historical ROICs?
o How do they compare with the WACC you compute below (in Question 4)? Do your projected ROIC and WACC imply that Target will create value for the investors?

(5) From 2021 to 2025, compute free cash flows to the firm (FCFF).

4. [Estimating the Cost of Capital] Estimate Target's weighted average cost of capital (WACC) by following the instructions below.
(1) Estimate the cost of equity using the Capital Asset Pricing Model (CAPM). Use a historical market risk premium estimate from Class Note 3B - Cost of Capital, and justify your choice of the variables and time period.
(2) Estimate the cost of debt using a "spread approach." 6
(3) Estimate the following capital structure ratios, where value (V) = equity (E) + debt (D) (2 points).
a. Equity-to-value (E/V)
b. Debt-to-value (D/V),7 where debt = current portion of long-term debt + long-term debt.
(4) What is your resulting WACC incorporating the costs of the equity and debt capital for Target?

5. [Wrap up DCF Valuation] In this final step of DCF valuation, we will compute the enterprise, total firm, and equity values of Target by estimating the terminal value and discounting free cash flows to the firm using the WACC.
(1) Estimate the terminal value that captures the present value of FCFFs from 2026 and onward following the instructions below.
a. What is your estimate for the terminal growth rate (g)? Please justify your choice of g.

b. What is your estimate for the terminal return on invested capital (ROIC)? Please justify your choice of ROIC.
c. Then, please compute a steady-state reinvestment rate (b) using the following steady-state relation: reinvestment rate (b) = g / ROIC. Does the implied reinvestment rate (b = g/ROIC) make sense? Please discuss.
d. Lastly, compute the terminal value using the following "value driver" formula based on NOPAT, g and ROIC.
(2) By discounting FCFF using the estimated WACC, compute enterprise value (i.e., value of operating assets). Then, compute total firm value by adding (any) excess cash to enterprise value. Excess cash is defined as any cash & cash equivalents and short-term investments less operating cash on the balance sheet from the latest 10-K or 10-Q. Compute equity value of Target by subtracting the market value of debt (computed in Question 4) from total firm value.

6. [Valuation Conclusion] Based on your multiples and DCF valuations, state your assessment of Target's equity as a potential investment. Here, you would need to compare the equity values from your multiples and DCF valuation analysis with current market capitalization. If you are an equity analyst, would you recommend Target's equity to portfolio managers as a ‘buy?' If you are CFO of Target, what corporate payout policies would you recommend (such as stock buyback and dividends) given your own valuations vs. current market capitalization?

Attachment:- Valuation Project.rar