Finance 2FA3 Basic Valuation Group Project

Loblaw Companies

Commerce 2FA3: Introduction to Finance

Adeel Mahmood

Wednesday, June 17, 2020

Chiara Salvo
Charlotte Brunetti
Rachel Hutchison
Drew Simpson
Olive Ozulumba
 Table Of Contents

Part 2: Forecasted Income Statement 3

Part 3: Cash Flow from Assets 7
Part 4: Common Discount Rate 8
Part 5: Terminal Value of the Company 8
Part 6: Discounted Cash Flows and Market Value of Equity 9
Part 7: Market Value of Equity per Share 11
Part 8: Conclusion
Bibliography
Appendix
 Part 2: Forecast Income Statement

The forecasted income statements for each of the three scenarios can be found in Appendix A.
The explanations behind the predictions of the future growth rates can be found below.
The assumed tax rate used throughout the projections will be 25.2%, which we estimated at 25% going
forward for simplicity. We obtained this number from the Loblaws 2020 First Quarter Report to
Shareholders.

Scenario 1: Base Case

Appendix A, Figure 1

What is your assumption about the sales growth?

- The rise of COVID-19 brought about extraordinary sales growth for Loblaws in 2020. As the
number of infected persons increased, so did consumer demand and stockpiling, which then
resulted in an overall abrupt increase in revenue (Loblaw Q1 2020 Quarterly Report). After this
primary surge, the demand has become less extreme, but still continues to thrive in essential food
and pharmacy areas of business (Loblaw Q1 2020 Quarterly Report).
- As a result of the increase in popularity of online shopping and retail because of the COVID-19
social distancing measures, we can assume that the company can also expect a higher growth in
digital retail and delivery services in the future.
- After analyzing past financial statements and quarterly filings along with analyst research, we can
expect a near 8% increase overall for the 2020 sales period due to the reasons stated above. We
can anticipate the next 2 years to level off to more historic levels as stockpiling and other effects
related to COVID-19 decrease.
- We can then expect growth at a normalized rate which we calculated from previous company
annual filings to total out to approximately 1% per year.

What about the growth profit margin?

Cost of Goods Sold:
- We estimated the long-term COGS growth based on historical company data to be approximately
0.23% on average. In our estimations, we chose a higher COGS for the future two periods due to
management's concern as indicated in the financial filings regarding uncertainty in supply chains
and increased costs due to the COVID19 pandemic (Loblaw Q1 2020 Quarterly Report). These
costs would include items such as salary increases, higher benefits, supply chain increases
(farmers having to pay their workers more) potential shortages etc.
- We also noted that once the pandemic passes, COGS growth will level off and decrease to past
historic levels.

Other expenses?
SG&A (Selling, General, and Administrative Expenses)
- SG&A related expenses such as legal expenses, advertising expenses, sales incentives, corporate
overhead expenses, and other general and administrative expenses are expected to increase in the
future periods, but eventually level off to a previous historical growth rate of roughly 4.67%.

Non-Operating Interest Income

- Due to the potential medium to long term impacts of the covid-19 pandemic, we would expect
volatility with foriegn exchange, potential asset write downs, and losses from investments. We
 also expect non-operating income to decrease in the medium to long term, which is also in line
with a steady but slightly decreasing trend from previous years.

Unusual expenses
- Considering current economic circumstances of COVID-19 and its future effects, we would
expect the unusual expense line item to increase substantially in the short term, and then
eventually stagnate and return to normality in the long term.
- Some items which would affect this in the short term include: damage costs or slowdown of
operations, potential losses from lawsuits, etc which may be enacted during these turbulent times,
but are not expected to be ongoing in the long term.

Interest Expense
- Due to COVID-19, we would expect the acquisition of long-term debt obligations, which will
lead to an increase in the interest expense over the long term because of the need to fund large
capital projects. These include expenditures to improve online shopping capabilities and
enhancements to existing storefronts in order to better situate Loblaws through the COVID-19
pandemic. These expenditures would allow Loblaws to be a leader in the online food retail space.
- We have also considered the current low interest rates, as well as the fact that old debt may
potentially be refinanced at a lower rate. Nevertheless we expect the interest expense to increase
due to the large amount of debt that may be required for the situation.
- We estimated a large increase for 2020, and a consistent increase of 10% over the next years, as
interest rates may increase in the future and further capital may be required.

Scenario 2: Optimistic Case

Appendix A, Figure 2

What is your assumption about the sales growth?

- Using an optimistic sales approach, we estimated a large increase for 2020 and 2021 using the
highest range of estimated values for the time period.
- We also estimated that the increased sales would persist, and a constant long-term growth rate of
3.5% which is slightly higher than the upper range of the company’s long term annual rates.

What about the growth profit margin?

Cost of Goods Sold:
- Under an optimistic approach, we estimated that COGS would be stable for the 2020 period and
would decrease thereafter at a constant rate of 3.5%. This rate was derived using historic data
from the company and using a value slightly than the lower bounds of the range.
- This rate could be decreased by implementing more efficient processes that enable employees to
be more adept and productive, therefore decreasing the costs directly attributed to payroll and
sales.

Other expenses?
Selling, General, and Administrative Expenses:
- We assumed a modest increase in SG&A for the 2020 period, keeping in mind that there would
indeed be expenses attributed to COVID-19.
- Under the optimistic approach we then attributed an annual decrease in SG&A expenses going
forward. We used a constant rate of -1% to reflect this.
 - SG&A expenses would decrease due to a number of factors including: refinancing debt and
decreasing spending on advertising and promotional materials.

Non-Operating Interest Income

- Under the optimistic assumption, we used the upper bounds of the historic values to reflect
optimistic future values.

Unusual expense
- For 2020, we assumed that there would indeed be some unexpected expenses due to COVID-19,
but going forward we estimated the expenses to be at $50M keeping in line with the lower end of
the historic spectrum.
- This can be achieved by taking actions to minimize losses from restructuring charges, write offs,
and discontinued operations.

Interest Expense
- We assumed that interest expenses decrease over the long term.
- Reasons for this under optimistic circumstances include, refinancing existing debt at a lower
interest rate, and not having to take out additional debt.
- In addition, under optimistic circumstances, Loblaws can potentially use access cash reserves
from increased sales to pay off existing debt, therefore decreasing interest related expenses in the
future, until finally leveling out to a lower annual amount.

Scenario 3: Pessimistic Case

Appendix A, Figure 3

What is your assumption about the sales growth?

- We estimated a slightly higher 2020 figure due to stockpiling and panic buying. In later years we
assumed a zero growth synopsis, moving towards a constant negative growth rate of -1% in future
years.
- Under a pessimistic scenario, this negative growth can be attributed to factors such as competitors
moving into the market. For example, the rise of online grocery delivery services may pose the
threat of other, more adept companies entering into the market in the future. This has the potential
to decrease the revenue of existing Loblaws established physical locations. (Ex. Uber Eats
partnering with local lost-cost warehouse competitors and/or potentially direct from producers
like farms and production warehouses etc.)

What about the growth profit margin?

Cost of Goods Sold:
- We estimated a large COGS increase in 2020, and a constant growth rate going forward of 2.5%.
This increase is estimated using the upper bounds of historical financial data for the company and
adding a premium for future costs that can be related to COVID-19 and other industry and
economic factors.
- For example, supply chains can be negatively impacted if farms are forced to shut down due to
COVID-19, thus leading to increased costs overall.
- Wages also have the potential to increase if the workforce demands higher wages to compensate
for the ehealth and safety risks they have to endure in the workplace.
Other expenses?
Selling, General, and Administrative Expenses:
- We have estimated a high increase of SG&A in 2020 due to large potential expenses that the
company may come across.
- We also added a high constant rate going forward of 7.5% to reflect potential increase in related
expenses due to long term effects of COVID-19 and other factors in the industry.
- These expenses may increase due to additional marketing and advertising spending to make up
for potential lack of sales, and/or​ the need for a potential increase in the salaries of personnel in
certain departments unrelated to sales or production due to the danger of working during the
pandemic.

Non-Operating Interest Income

- We have estimated a constant decrease in non-operating interest income as investment projects
fall through, and a constant decrease in interest income is potentially accrued from the potential
negative economic outlook.
- We estimated a decrease over the 2020-2021 periods,and then a constant low rate to reflect low
possible non-operating interest income due to the reasons highlighted.

Unusual Expense
- As a result of unprecedented potential expenses due to COVID-19, costs related to additional
safety measures such as one time installations of plexiglass barriers, face shields, masks, gloves,
etc, are expected to increase.
- The values going forward are also higher than the historical values under the pessimistic
approach, as there is much uncertainty in the industry which may allow more unknown costs and
expenses to arise in the future.

Interest Expense
- We expect an increase in interest expense as a result of more debt being taken out to fund large
capital projects to adhere to COVID-19 safety measures. This may include events such as
periodic store closures and/or renovations, large IT infrastructure development to keep relevant in
the online retail space for groceries, and/or large purchases of equipment that may be necessary to
continue operations.
- In this case, we used upper bounds of historic data and added a 15% per year premium due to
uncertain future conditions and expected increase in expenses directly attributed to COVID-19.
- We used higher estimates for the 2020 period to reflect the access addition of debt to finance
projects required to comply with COVID-19 situation as stated above.
- As a result of losses being carried forward, no taxes are payable in the years where losses are
displayed.

Part 3: Cash Flow from Assets

Operating cash flow, OCF, can usually be computed with either a “top down” or “bottom up” method as it
follows respectively:
OCF = EBITDA ± changes in NWC - Taxes
OCF = Profit + Interest + D&A ± changes in NWC

NWC, stands for the net working capital.

NWC = | current assets - current liabilities |
NWC in this case is hard to accurately calculate because the cash flow statements roll numbers together,
but ultimately because we would have to project current assets and liabilities of each year or find the
difference between the beginning and final working capital. All of these cases require a projected balance
sheet.

Free cash flow can also be calculated directly from the net income, if changes in working capital and
investments in long-term assets are known. Instead, OCF for each cash flow was calculated using this
formula:
OCF = EBIT + D&A - taxes

Considering Figures 1 to 3 calculated EBIT not EBITDA, and how the expenses were defined and
grouped above, the majority of stated net income is actually cash. See Figures 3, 4, 5 to see the calculated
cash flow per year.

Part 4: Common Discount Rate

A common discount rate is to be used in all present value calculations for all three scenarios. Under the
assumption that the weighted-average cost of capital (WACC) is the same as the equity discount rate
calculated with the capital asset pricing model (CAPM), the risk-free rate, the market return and the beta
of the stock is required.

The risk-free rate will be standardized at 2% based on the Treasury bill rate retrieved from the Bank of
Canada (Canada). The market return rate will be standardized at 8%, based on the annualized return
observed on a major market index over several years. Lastly, the company beta obtained from the Yahoo
Finance website shows a value of -0.08.

The CAPM formula used is:

ER​i​ = R​f​ + β​i​ (ER​m​- R​f​)

In the formula, ER​i​ is the expected return, R​f​ is the risk-free return, β​i​ is the beta of the investment, and
ER​m​ is the expected market return.

Using the previously gathered values:

ER​i​ = 0.02 + -0.08 (0.08 - 0.02)

ER​i​ = 0.0152 or 1.52%

Hence, the discount rate of 1.52% is equal to the WACC and will be used to discount cash flows.

Part 5: Terminal Value of the Company

In order to estimate the constant growth rate for each scenario, percentage changes for the cash
flows from assets were calculated each year. A plot of the percentage changes per year is plotted below.
As we can see, the growth rate fluctuates from year to year. In order to estimate a constant growth rate to
use in the following calculations, an average of the forecasted growth rates is taken and calculated to be
0.78%. Therefore, it is reasonable to assume that a constant growth rate of 0.78% can be used in the
calculations below.

Scenario 1: Base Case

The sixth-year cash flow from assets as forecasted and calculated in part 2 and 3 is $5,413. This will be
used to calculate the terminal value at the end of year 5 (P​5​), with ‘r’ being the discount rate and ‘g’ being
the estimated growth rate (0.78%). The formula used is:

P​5​ = ​CFA​6
r-g

We calculated in part 4 that the discount rate is 1.52%.

By substituting the numbers into the equation above, we get a base case P​5 ​ of: $731,486.49

This method is repeated for each case.

Scenario 2: Optimistic Case

The sixth-year cash flow from assets as forecasted earlier in parts 2 and 3 is $22,389. Therefore,
by using the same discount rate and estimated growth rate as above, the terminal value of the company at
the end of the fifth year is $3,025,540.54.

Scenario 3: Pessimistic Case

The sixth-year cash flow from assets as forecasted earlier in parts 2 and 3 is -$6,908 . Therefore,
by using the same discount rate and estimated growth rate as above, the terminal value of the company at
the end of the fifth year is -$933,513.51.

Part 6: Discounted Cash Flows and Market Value of Equity

Discounting the Cash Flows
For each scenario, all cash flows from assets and the terminal values need to be discounted to the
present time (today). In doing so, this will provide us with the net present value of the cash flows from
assets, also known as the enterprise value of the firm. These calculations are computed like so:

EV​0​ = ​CF1​ + ​CF2​ + ​CF3​ + … + ​CF5 + P5

(1 + r) (1 + r)​2 ​(1 + r)​3​ (1 + r)​5

Where: V​0​ = the value of the firm today

r = discount rate
CF = cash flow

Scenario 1: Base Case

Substitute the cash flows and the discount rate into the equation above and solve for V​0​.

EV​0​ = ​5256​ + ​4529​ + ​4855​ + ​5302​ + ​5361​ + 7​ 31,486.49

(1+0.0152) (1+0.0152)​2​ (1+0.0152)​3​ (1+0.0152)​4​ (1+0.0152)​5​ (1+0.0152)​5

= $702,516.21

Therefore, the Net Present Value of the company today is: $702,516.21

Repeat this method for both the optimistic case and the pessimistic case.

Scenario 2: Optimistic Case

The Net Present Value of the company is: $2,873,331.41

Scenario 3: Pessimistic Case

The Net Present Value of the company is: -$872,184.36

Market Value of Equity

We can now use the enterprise value of the firm to calculate the market value of equity for each
scenario. In addition to the enterprise value, we also need the Net Debt. Net Debt is calculated using the
following formula:

Net Debt = Debt - (Cash + Cash Equivalents + Short-Term Investments)

The market value of equity is then calculated using the following formula:

Market Value of Equity = Enterprise Value - Net Debt

Scenario 1: Base Case

Net Debt = Debt - (Cash + Cash Equivalents + Short-Term Investments)
= 7841000 - (2341000 + 57000)
= $5,433,000
Market Value of Equity = Enterprise Value - Net Debt
= 702,516.21 - 5,433,000
= -$4,730,483.79
Repeat this method for both the optimistic and pessimistic cases.

Scenario 2: Optimistic Case

Net Debt = $4,691,250
Market Value of Equity = Enterprise Value - Net Debt
= 2873331.41 - 4691250
= -$1817918.59

Scenario 3: Pessimistic Case

Net Debt = $7059160
Market Value of Equity = Enterprise Value - Net Debt
= -872184.36 - 7059160
= -$7,931,344.36

Part 7: Market Value of Equity per Share

Using the fully diluted number of shares from the previous financial statement, Q1 2020.
Diluted net earnings per common share ($) $ 0.66

Base Case

Market price of the company

Share price at March 31st 2020, ​$72.55
Shares outstanding = ​357.73M
Diluted Earnings Per Share = ​$0.66

Market value(MV)​ = Current Stock Price(PV) x Number of Outstanding Shares

Market Value at March 31st 2020 (End of Q1)

= $72.55 x 357.73M

Market Value(MV) = $25,953.31

Price to Earnings Ratio ​= Share Price ÷ Earnings per Share (EPS)

P/E ratio = 72.55/0.66

P/E ratio = 109.92

Intrinsic Value = P/E Ratio X Earnings Per Share

Intrinsic Value = 109.92 x 0.66
= 72.55
Optimistic Case

Increase share price to ​80.55

Market value (MV) ​= Current Stock Price(PV) x Number of Outstanding Shares
= 80.55 x 357.73
= $28,815.15

Pessimistic Case

Reduce share price to ​64.55

Market value (MV)​= Current stock price (PV) x Number of outstanding shares
= 64.55 x 357.73
=$23,091.47

Current share price as of June 17th 2020 is ​$65.84. ​The current share price is lower than at the
end of Q1 (72.55). This can be due to a number of factors. The ongoing pandemic seems to be the most
obvious factor. As there is steady decline in share prices since the beginning of April 2020 (Google
Finance, 2020). This decline is tolerable compared to other companies during this time. Loblaws being
considered an essential company providing necessities to Canadian families might be responsible for the
tolerable decline during the pandemic.

Part 8: Conclusion

If PV > market price ; buy the stock because the price is undervalued.
If PV < market price; sell the stock because the price is overvalued.

The observed market price is $65.84. The intrinsic value(PV) calculated in Part 7 was $72.55. Because
the intrinsic value is greater than the current market share price, we should buy the stock as it is
undervalued. The current market price is lower than the average price over the last six months as seen in
the above figure therefore, we should buy the stock as it is currently undervalued(Yahoo Finance, 2020).
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Figure 6: