1Valuation Project: Target (NYSE: TGT) – Parts I & II This is a sample valuation project. There are six (6) pages in total in this project description. Deliverables: Please submit a 7-8 page write-up containing answers to the following questions, and attach anysupporting tables and figures as appendices to the write-up (and a separate Excel file with calculations). Please submit both Parts I & II of the project in one file. In your write-up, please clearly state and justify key assumptions you make and name sources of all inputsto your valuations. BackgroundTarget 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 storesacross the US. Since April 2020, the company’s share price has outperformed the S&P 500 by 55%, thanksto its strong sales and earnings growth during the pandemic period. For example, the company has beatenanalyst consensus sales and earnings estimates four quarters in a row since the first quarter of 2020. Inparticular, Target’s e-commerce sales growth has outperformed other retail peers such as Walmart andHome 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’sequity will outperform the market. 1 However, continued investment in the company’s e-commerceinfrastructure, 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 mediumto long run. Therefore, Target’s equity poses both potential challenges and opportunities to analysts andinvestors: On the one hand, the recent outperformance relative to the overall market as well as the retailpeers might indicate that the company’s equity now fully reflects its fundamentals or is even potentiallyovervalued. On the other hand, Target’s equity may still offer an attractive investment opportunity, if thecompany’s future outlook for generating free cash flows and growth, given the risk, more than justify thecurrent valuation. Therefore, the conclusion as to whether Target is an attractive investment should dependon your careful valuation analysis that incorporates its fundamental cash flow generating abilities and pricesof the company as well as other comparable companies.Deliverables:0. [Executive Summary] On the first page of your write-up, please include a one-paragraph executivesummary of your multiples and DCF valuation analysis results.1 As of April 2021, five analysts have ‘buy,’ 13 ‘outperform,’ and 10 ‘hold’ but no ‘underperform’ or ‘sell’recommendations. Source: FT-Equities.21. [Relative Valuation using Multiples] Estimate the (1) total equity value and (2) per-share equity valueof 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 groupof firms in the same or similar industries from Capital IQ (‘Peer Analysis’-‘Quick Comps’) orFactSet (‘Company/Security’-‘Overviews’-‘Comps’). Optional: You can add and/or remove somecompanies to/from the set, if you’d like. In that case, please explain your justification (e.g., excludenon-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 andfiscal year 20212 consensus forecasted sales (S) for this initial set of comparable firms, as well asTarget.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 valuedrivers 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 into2022/2023)b. Net income margins = net income/salesc. 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 theinitial 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 onqualitative characteristics (e.g., geographic location, business models) will not suffice.2 Target’s fiscal year ends on the Saturday closest to January 31 in the following year. Therefore, its 2021 fiscal yearwill end on January 29, 2022, yet it is called ‘fiscal 2020’ (essentially because it is much closer to the end of calendaryear 2021). Similarly, many peer companies in the retail sector also end their fiscal years in January or February ofthe following year.3 Forward multiples are computed using forecasted, future fundamentals such as earnings and sales in the future, asopposed to historical, realized ones. Sources of these estimates by analysts include: Capital IQ (under ‘Estimates’-‘CIQ Estimates’), FactSet (under ‘Company/Security’-‘Estimates’-‘All Estimates’), and www.ft.com Markets Datasection. If you are using Capital IQ’s CIQ Estimates section, note that “fiscal years YYYY” there are actually fiscalyears that ends in calendar year YYYY. For example, Target’s “fiscal year 2022” in that section represents a fiscalyear ending in calendar 2022, which is its fiscal year 2021.3(5) Compute the implied total equity value of Target. Specifically, multiply its fiscal 2021 forecastedsales by a “typical” (e.g., mean, median) P/S multiple for the set of comparable firms you choosein part 4). Then, compute the implied per-share equity values of Target by scaling the impliedequity value by the number of shares outstanding.2. [Preparing Historical Data for DCF Valuation] In this question, we will compile historical financialstatements 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 cashflows to the firm (FCFF) and other key line items of Target’s over the past five years using the incomestatement, balance sheet, and statement of cash flows collected from available data sources (such as 10-Ksfrom 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 NOPATo 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 assetso Current operating liabilities = sum of the following items: Accounts payables Accrued expenses Current income taxes payable Unearned revenues, current Other current liabilitieso 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)4 Target’s fiscal year ends on the Saturday closest to January 31 in the following year. For example, its fiscal year2020 ended on January 30, 2021. See also footnote 2.4(2) From fiscal years 2016 to 2020, compute the ratio of each of the above line items to revenue (exceptfor 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’sfree cash flows to the firm (FCFF) over the next five years (that is, from fiscal years 2021 to 2025) usingsales 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. Theultimate goal here is to project net operating profits after taxes (NOPAT). Fully explain andjustify your projection of each of the ratios:o Cost of goods sold (COGS)o Selling, general, and administrative (SG&A) expenseso Depreciation and amortizationo Operating profitso 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. Theultimate goal here is to project invested capital (IC). If you think it is sensible, you can choose tocombine some line items in your projection (e.g., items that are of a tiny fraction of sales).5 Fullyexplain 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 assetso Current operating liabilities: sum of the following items Accounts payables Accrued expenses Current income taxes payable Unearned revenues, current5 In that case, clearly state in your write-up which items you choose to aggregate and explain your reasoning.5 Other current liabilitieso 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 / previousyear’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 yourprojected 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) byfollowing the instructions below.(1) Estimate the cost of equity using the Capital Asset Pricing Model (CAPM). Use a historical marketrisk premium estimate from Class Note 3B – Cost of Capital, and justify your choice of the variablesand 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, totalfirm, and equity values of Target by estimating the terminal value and discounting free cash flows tothe firm using the WACC.(1) Estimate the terminal value that captures the present value of FCFFs from 2026 and onwardfollowing the instructions below.a. What is your estimate for the terminal growth rate (g)? Please justify your choice of g.6 Refer to Class Note 3B – Cost of Capital. First, you can obtain Target’s long-term (LT) credit ratings of publiccorporate debts from Capital IQ–Fixed Income–Credit Ratings. Second, you can estimate the cost of debt for Target’sas “risk-free rate + default spread” for the credit rating and assuming an average 10-year maturity. You can obtaincurrent corporate bond yield spreads by credit rating from the St. Louis FED database:https://fred.stlouisfed.org/categories/32348?t=option-adjusted%20spread7 It is advisable to use a measure of market value of debt, instead of book value. You can approximate the marketvalue of debt for Target by multiplying the book value of debt from the most recent balance sheet by 1.15, which is arecent weighted average market price of the company’s debt outstanding relative to the book value of debt. The highermarket value relative to book value of debt is (in part) due to a recent decline in market interest rate.6b. What is your estimate for the terminal return on invested capital (ROIC)? Please justifyyour choice of ROIC.c. Then, please compute a steady-state reinvestment rate (b) using the following steady-staterelation: 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 onNOPAT, g and ROIC.(2) By discounting FCFF using the estimated WACC, compute enterprise value (i.e., value ofoperating assets). Then, compute total firm value by adding (any) excess cash to enterprisevalue. Excess cash is defined as any cash & cash equivalents and short-term investments lessoperating cash on the balance sheet from the latest 10-K or 10-Q. Compute equity value ofTarget by subtracting the market value of debt (computed in Question 4) from total firmvalue.6. [Valuation Conclusion] Based on your multiples and DCF valuations, state your assessment ofTarget’s equity as a potential investment. Here, you would need to compare the equity values from yourmultiples 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) givenyour own valuations vs. current market capitalization?
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