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Part Two - Term Project Course: AFF420 041 Professor: Lu Zhang Date: April 7th, 2022 Companies Costco Wholesale Corporation McDonald’s Corporation Lululemon Athletica, Inc.

Executive Summary Costco Wholesale Corporation We recommend to buy Costco’s stock based on the intrinsic valuation. The current stock price of $575.13 is trading below the intrinsic value of $603.71 based on the two-stage FCFF model. On the other hand, the current stock price is trading above the relative value of $366.02 based on a PS sector regression on comparable firms. The recommendation is based on the intrinsic value since it is a more proper valuation and estimate rather than using comparables to estimate the value of equity per share. McDonald’s Corporation We recommend to buy McDonald’s Corporation’s stock based on the intrinsic valuation. The current stock price is $248.51 which is lower than the intrinsic value of $348.79. According to the relative valuation model with P/S sector regression analysis, the stock price is $169.35 is much lower than the current stock price. Therefore, it is appropriate to make the recommendation based on the intrinsic value that estimates the equity per share. Lululemon Athletica, Inc. We recommend selling Lululemon’s shares based on the intrinsic valuation. The current stock price trading on the market is $367.44 which is much higher than the intrinsic value of $138.14 based on the two-stage FCFE model. Based on the relative valuation model with the price-to- sales ratio sector regression analysis, the equity price per share of $66.58 is also lower than the current stock price. However, the recommendation is based on the intrinsic value since it is a more reliable valuation. The assumptions used in the intrinsic valuation model are reasonable. Valuation Analysis

Costco Wholesale Corporation 1) Intrinsic valuation Two-stage FCFF Model The two-stage FCFF model is an appropriate valuation for Costco since its financial leverage has been unstable based on the 10 year period from 2012 to 2021. In some years, its D/E ratio has increased or decreased by a significant amount (see appendix). This is relatively due to the change in equity from year to year. As for the two-stage growth, Costco’s EBIT has been growing at a moderate rate in the last 10 years. Based on the geometric average, its EBIT is growing by 11.43% each year. Assumptions High growth Stable growth Length of growth period 10 years Perpetuity Growth rate 11.43% 2% Return on capital 24.24% 4% Reinvestment rate 47.15% 50% Risk-free rate 2.40% 2.40% Equity-risk premium 4.24% 4.24% Beta 0.68 0.68 Marginal tax rate 27% 27% Debt ratio 33% 20% Equity ratio 67% 80% Cost of debt 3.15% 3.15% Cost of equity 5.28% 5.28% Cost of capital 4.30% 4.68% Costco will continue to grow in the high-growth stage for 10 years at a rate of 11.43% based on the geometric growth of EBIT. It will reach its stable-growth stage after year 10, at the projected U.S. GDP growth of 2% in 2033.

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As Costco already faces strong competition in the discount store industry, I predict the competition will likely increase in the future. As a result, its ROC should significantly decrease to 4% in the stable-growth period. This leaves the reinvestment rate to be 50%, which is relatively close to the rate in the high-growth stage. Furthermore, I also assume its debt ratio and equity ratio will change in the stable-growth period. I expect a slight increase in the equity ratio as Costco’s capital structure consists mainly of equity. All other inputs will remain the same. Based on these inputs the valuation is as follows: Terminal value $333,898 million Firm value $277,099 million Equity value $267,577 million Equity value per share $603.71 Current stock price $575.13 Therefore, the stock is undervalued based on the intrinsic valuation. Sensitivity Analysis The key driver is the high-growth rate in EBIT. Discount stores are a very competitive industry, therefore the actual growth rate in EBIT could be lower or higher than 11.43%. The equity value per share will be revalued based on the high-growth rates below: High growth rate Equity value per share 6% $382.97 8% $453.40 10% $536.08 11.43% (base rate) $603.71 12% $632.91 14% $746.03 2) Relative valuation 8 companies were used as comparables (see appendix). The comparables chosen are U.S. publicly traded discount store companies in the consumer defensive sector that generated revenues of more than $1 billion in the most recent fiscal year. The comparables were further

selected based on similar betas ranging from 0.5 to 1. Big Lots Inc. was excluded as its beta is out of range. The multiple chosen is the PS (Price to Sales) ratio. It is appropriate for the comparables chosen as their primary focus is to generate high sales and profits as discount store companies. Regression analysis: P/S vs Net profit margin, Expected growth, Payout ratio The regression equation is: Predicted PS = 0.18 + 13.03*net profit margin + 2.25*expected growth + 0.0009*payout ratio Actual P/S = 1.21 Predicted P/S = 0.77 The equation yields a predicted P/S of 0.77, resulting in the equity value per share of $366.02. The current stock price is $575.13, therefore the stock is overvalued based on the relative valuation. 3) Final Analysis and Recommendation Option Pricing Model The option pricing model is not applicable to Costco. The equity value per share can not be derived since Costo is not a firm in financial distress, it is a very profitable firm with no negative earnings. The firm’s value is higher than the total outstanding debts. Therefore, applying the option pricing model would be an inaccurate representation of the equity value per share. Final Analysis Current stock price (22/04/04) $575.13 Intrinsic value (2-stage FCFF) $603.71 Relative value (P/S sector regression) $366.02 Recommendation Buy The current stock price is undervalued when compared to the intrinsic value, and it is overvalued when compared to the relative value. I would put more weight in the intrinsic value as choosing comparables has some ambiguity. Furthermore, it is safer to rely on the intrinsic value as it is a proper valuation rather than the relative value where it is pricing and comparing like firms.

Therefore, as the current stock price is trading below the intrinsic value, we would recommend “ buy ”. McDonald’s Corporation 1) Intrinsic Valuation

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We choose to use the stable growth FCFF model to valuate McDonald’s Corporation because its leverage is unstable, and its growth rate is under U.S. Real GDP growth rate. 2020 2019 2018 2017 2016 2015 Total Debt (in million) 37,440 34,177 31,075 29,536 25,956 24,122 Below are the key assumptions we used to build this DCF Model: Input High Growth Stable Growth Length of growth period 0 Forever Growth rate 0 3.19% Beta 0 0.60 Risk-free rate 0 2.55% Equity Risk Premium 0 4.24% Tax Rate 0 27% Cost of Debt 0 3.69% Cost of Equity 0 4.61% Reinvestment Rate 0 22.36% Considering that FCF, in 2020, was estimated at $4,180, the values provide ground to predict that the company’s future cash flows are stable and the company may continue to GROW give good dividends in the future. This is thus a good potential stock to invest in with promising returns. The DCF Model shows that the Weighted Average Cost of Capital is 4.61%. This cost of capital may be considered low because given that it is a publicly listed company, it shows that the returns on investment are much lower. However, based on industry evaluation, it can be presumed to be acceptable when compared to the industry average. The equity value per share based on the intrinsic valuation is $348.79 per share, and the current stock price is $248.51 USD per share; therefore, McDonald’s Corporation is undervalued .

Sensitivity Analysis: Growth Rate (Stable growth period) Equity per share (Stock price) 1% $96.84 1.5% $123.11 2.0% $159.48 2.5% $213.16 3.0% $300.36 3.5% $466.74 4.0% $909.81 Based on the key assumptions, the intrinsic valuation gives a Market value of with and equity of $186,942.85, with a value of equity of $348.79. Assuming all other variables to be constant, the Stable growth experienced was estimated at 3.19% based on a reinvestment rate of 22.36%. Therefore, the Growth Rate (Stable growth period) of 3.0% gives a Stock price of $ 300.36 . On the other hand, the growth rate of 3.5% gives a stock price of $466.74 . These values are comparable with the price obtained by the intrinsic valuation of $348.79. 2) Relative Valuation 16 firms in the retail industry were used as comparables. The selection criterion was based on companies with values more than $2 billion in the U.S. that traded publicly. Some of the companies included McDonald's Corporation, Restaurant Brands International Inc., and Yum! Brands, Aramark, and Blooming Brands Inc. The book value of a corporation is the amount of money shareholders would get if the firm's assets were liquidated and if its liabilities were paid off. On the one hand, the intrinsic valuation shows that the book value of debt is $48,518.10. The market value of a corporation is determined by the current stock price and the number of outstanding shares, as determined by the markets. Predicted P/S 6.57

Total Revenue $19,207.80 Shares Outstanding (in million) 745 Market Value of Equity $126,164.93 Equity per share (stock price per share) $169.35 The analysis results show that the Market value of equity is $126,164.93 while that of the Equity value per share is $169.35 . Therefore, the market value of equity is lower than the value obtained in the intrinsic valuation by 48%. Additionally, the value of equity is higher by a margin of 105%. Based on the findings, the predicted P/S for the company was $6.57 while on the other hand, the Total Revenue in the financial year 2020 was $19,207.80 quoted in millions. On the other hand, the Shares Outstanding were 745 million. Considering the 16 companies held, it is remarkable that 7 had actual P/S ratios that were overvalued while 9 had actual P/S ratios that were undervalued, raising the concern for careful trading to minimize risk. Since McDonald’s Corporation is in restaurant chain of retail industry, we decided to choose revenue multiples. The reason that we prefer to use price/sales ratio instead of using EV/Sales is because we think the key driver should be net profit margin. Coefficients Intercept 5.473410596 Net Profit Margin X Variable 1 8.157052369 Beta X Variable 2 -2.457169048 Payout Ratio X Variable 3 -0.154740714 The Regression equation obtained from the model is: Price/sales ratio = 5.4734+8.1571*Net Profit Margin-2.4572*Beta-0.1547*Payout Ratio. Actual P/S = 8.03

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Predicted P/S = 6.57 This shows that the Net profit Margin is very strong given its 8.1571 coefficient value which is high. Based on this relative valuation, the actual P/S is higher than the predicted P/S; thus McDonald's current stock price is overvalued. 3) Final Value Estimate and Recommendation Option Pricing Model: The Options Pricing Model is not applicable to McDonald’s Corporation. McDonald’s Corporation is not a company under financial distress, it has positive earnings. As well as, the firm value is higher than the outstanding debts. Current stock price (22/04/05) $248.51 Intrinsic Value (Stable Growth FCFF Model) $348.79 Relative Value (P/S sector Regression) $169.35 Recommendation Buy, In summary, based on the data presented, it would be advisable to invest in the stock given its potential viability in the middle term. The final decision is, therefore, to buy the stock as the fundamentals in the market environment are fairly placed in its favour. The potential returns on investment are promising and, therefore, an investor will be able to make returns on their investment.

Lululemon Athletica, Inc. 1) Intrinsic Valuation We chose to use the two-stage growth FCFE model to estimate Lululemon Athletica Inc. because this is the most suitable model. First, the firm has had zero long-term leverage for the past few years and would be likely to achieve its consistent performance without long-term debt, thus FCFE model is relevant. Lululemon has only the non-interest-bearing operating leases for the past years, but according to both IFRS and GAAP, it is required for the companies to capitalize leases that result in debt on the balance sheet. This wouldn’t make a difference because Lululemon would continue to maintain the level of its operating leases. Second, we chose to use a two-stage growth model because the growth rate we calculated by using the financial statements for the year 2020 was 8.23%, therefore the overall growth rate is less than 10 percent which means the firm is growing at a moderate rate. Below is the key assumptions we used to build the DCF model: High Growth Stable Growth Length of growth period 1 - 5 Forever Growth Rate 8.23% 3.50% Bottom-up Levered Beta 1.32 1.15 Risk-free Rate 2.36% 2.36% Equity Risk Premium 4.24% 4.24% Marginal Tax Rate 26.50% 26.50% Return on Equity (ROE) 68.58% 29.17% Equity Reinvestment Rate 12.00% 12.00% Cost of Equity 7.96% 7.24%

Cost of Debt 0.00% 0.00% We assumed the stable growth rate of 3.50% starting in year 6 because the stable growth must be lower than the current Canadian real GDP growth rate which is about 4.0% in 2022. Besides, we assumed the cost of debt to be 0% even though the firm has lease obligations and it is non-interest bearing. In addition, we assumed the equity reinvestment rate will remain constant in the future. Based on the inputs above valuations are as follows: For the cost of capital calculation, we used the assumptions given above to find out the market value of equity using its current stock price of $367.22 and find the book value of debt. Then, we plug the values into the formula and calculate the WACC also known as the cost of capital. For the free cash flow calculations, we used the net income of the firm in the year 2020 and used the formula of FCFE = net income*(1 – reinvestment rate) to find out the estimated free cash flow to equity

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for both the high and stable growth stages. The equity reinvestment rate was assumed to be constant throughout the years at 12%. After finding out the free-cash-flows to the firm, we then calculated the terminal value by using the FCFE of year 6 and dividing by the stable cost of equity minus stable growth. Then, we used the NPV function with the high growth stage cost of equity to find the total value of equity. Following, we divided the value of equity by the number of shares outstanding of Lululemon Inc. in the year 2020, which had 124,090 thousand shares outstanding. The equity value per share based on the intrinsic valuation is $138.14 per share and the current stock price of $367.44 . Therefore, Lululemon Athletica Inc. is “overvalued ”. Sensitive Analysis: One of the key drivers we chose to use is the stable growth rate, increment by 0.5% starting with 2% and to 5%. As you can see, the higher the stable growth rate is, the higher the equity value per share is. Besides, the percentage change of the equity value per share year by year also increases. 2) Relative Valuation 21 comparable companies were used for Lululemon Athletica Inc. The selection of the comparable firms is based mainly on total retail sales ranging from $1 billion to $10 billion US dollars in the retail industry.

The multiple we chose to analyze was the Price/Sales Ratio. Since Lululemon Athletica Inc. is part of the retail chain, revenue multiples are the better fit. Second, we chose the Price/Sales ratio over EV/Sales because we think the key driver "net profit margin" gives a better understanding of the net profit over its revenue for the shareholders. Sector Regression Analysis : Price/Sales vs. Net Profit Margin, Beta, Payout Ratio, Expected growth The regression equation is ; Predicted P/S = 0.44 + 1.49*Net profit margin + 0.37*Beta -2.01*Payout ratio + 3.90*expected growth Actual P/S = 6.50 Predicted PS = 1.88 Based on this regression, Lululemon’s predicted P/S ratio is about 1.88 with the predicted equity value per share of $66.58. The current stock price is $367.44 , therefore the stock is “ overvalued ” based on the relative valuation. 3) Final Value Estimate and Recommendation Option Pricing Model The option pricing model is not applicable to Lululemon. The main source of income is from sales which are not derived from call or put options. Lululemon is not in financial distress because it has zero long- term debt and positive earnings. Therefore, the option pricing model would not be applicable in valuing the equity value per share. Final Analysis Current stock price (22/04/03) $367.44

Intrinsic value (2-stage FCFE) $138.14 Relative value (PS sector regression) $66.58 Recommendation Sell The current stock price is overvalued when compared to both the intrinsic and the relative values. We think the intrinsic value would be more reliable because the comparable companies chosen for the relative valuation varies. In addition, it is better to rely on intrinsic valuation when estimating the value of equity or the firm. Overall, as the current stock price trading is higher than the value estimated by the intrinsic valuation, we would recommend “sell ”.

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Appendix Costco Wholesale Corporation McDonald’s Corporation Lululemon Athletica Inc. Fiscal year-end August 31 December 31 January 31 Industry Discount stores Restaurants Apparel Retail Currency in valuation U.S. Dollar (USD) U.S Dollar (USD) U.S Dollar (USD) Risk-free rate 2.40% 2.55% 2.36% Equity risk premium 4.24% 4.24% 4.24% Beta 0.68 0.60 1.32 Marginal tax rate 27% 27% 26.50%

Cost of debt at the start of DCF 3.15% 3.69% 0% Cost of equity at the start of DCF 5.28% 5.10% 7.96% Cost of capital at the start of DCF 4.30% 4.60% 7.84% Cost of capital in perpetuity 4.68% 4.60% 7.13% Length of the high growth period 10 years 0 5 years High growth rate 11.43% 0 8.23% Perpetual growth rate 2% 3.19% 3.50% Multiple used in relative valuation Revenue, P/S ratio Revenue, P/S ratio Revenue, P/S ratio Multiple value 0.77 6.57 1.88 Estimated value of equity per share (DCF) $603.71 $348.79 $138.14 Estimated value of equity per share (Relative) $366.02 $169.35 $66.58 Stock price as of __________ (date) $575.13 $248.51 $367.44

April 4, 2022 April 5, 2022 April 3, 2022 Final recommendation BUY BUY SELL Excel Calculations: Costco Wholesale Corporation Intrinsic valuation Financial leverage over the 10 year period Step 1 : Calculating the growth rate for the high-growth stage using historical data of EBIT. The geometric rate of 11.43% is chosen. Step 2: Calculating the adjustments for EBIT and debt using the inputs below. The present value of the operating leases is already calculated in Costco’s annual report. The formulas used are:

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Adjusted EBIT = EBIT(TTM) + Operating lease pmt - Depreciation of operating lease Adjusted Debt = Book Debt + PV of operating leases Step 3: Filling the assumption table. ● The reinvestment rate in the high-growth stage was calculated using the following formula: (Capex - Depr + Changes in NWC) / [EBIT*(1 - t)] ● The debt ratio and equity ratio in the high-growth stage is derived from the Adjusted Debt and Book Equity (MRQ) ● The cost of debt is calculated using the synthetic rating method where, Rd = Rf + Default Spread based on Interest Coverage Ratio Step 4: Estimating the FCFF and equity value per share ● FCFF = EBIT*(1-t)*(1 - reinvestment rate)

Relative Valuation ● Qualitative information on all companies were obtained from Yahoo finance ● Comparables were chosen by industry (Discount stores) and sector (Consumer defensive), primarily U.S. companies ● Big Lots Inc. was excluded in the regression as its beta is out of range ● Stock prices are as of April 4, 2022 ● Sales and earnings per share are twelve months trailing ● Expected growth rate is for the next 5 years

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McDonald’s Corporation

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Lululemon Athletica, Inc. Relative Valuation Step 1: Finding and calculating the inputs required for calculating the equity reinvestment rate, ROE, growth rate and the cost of equity. Step 2: Calculating the WACC/Cost of capital Step 3: Use the assumptions and inputs to calculate the terminal value, value of equity and value per share

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Step 4: Sensitive Analysis, using data table, column input as the stable growth rate Relative Valuation Step 1: Use the regression function to find the formula for the relevant equation Y input = Actual P/S X input = net profit margin, beta, payout ratio and the estimated growth

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Step 2: Use the equation found on step 1 and calculate the predicted P/S for Lululemon Step 3: Use the Lululemon’s predicted P/S to calculate its equity value per share References

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Costco Wholesale Corporation Financial Information Website: https://investor.costco.com/ Yahoo Finance: https://ca.finance.yahoo.com/ Risk-free rate: https://www.cnbc.com/quotes/US10Y Equity-risk premium: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html Projected U.S. GDP growth: https://www.cbo.gov/publication/56965 Default Spread Synthetic Rating: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/syntrating.htm Marginal tax rate: Corporate Marginal Tax Rates (nyu.edu) McDonald’s Corporation Publicly Traded U.S. Restaurant Chains: https://www.thebalancesmb.com/publicly-traded-us- restaurant-chains-2892798 Yahoo Finance: https://ca.finance.yahoo.com/ McDonald’s Corporation annual report: https://www.annualreports.com/HostedData/AnnualReports/PDF/NYSE_MCD_2020.pdf https://corporate.mcdonalds.com/content/dam/gwscorp/nfl/investor-relations-content/annual- reports/2019%20Annual%20Report.pdf Country Default Spreads: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html Default Spread Synthetic Rating: https://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/ratings.html Marginal tax rate: Corporate Marginal Tax Rates (nyu.edu) Lululemon Athletica, Inc. Top 100 retailers: Top1002021 (risnews.com) Yahoo Finance: https://ca.finance.yahoo.com/ Current Canadian real GDP growth: The Daily — Gross domestic product, income and expenditure, fourth quarter 2021 (statcan.gc.ca) Lululemon’s Financial Statements: Annual Reports | lululemon U.S 10 year Treasury: US10Y: 2.65% +0.041 (0.00%) (cnbc.com) Equity-risk premium: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html Marginal tax rate: Corporate Marginal Tax Rates (nyu.edu)

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