It is absolutely amazing to us how many investors can get spooked by the alleged leaking of an unconfirmed internal memo about a company's sales trends. Has the market really succumbed to such near term thinking? At the worst, the memo is true and Wal-Mart had poor performance over a period of TWO weeks in February. Are we that foolish to think that these two weeks are an indication of the long-term trends to follow at Wal-Mart?
Well, that's why we use a rigorous discounted cash-flow methodology at Valuentum that dives into the true intrinsic worth of companies. When others get spooked, we know what really drives the intrinsic value of a company -- and trust us, it's not performance over a two week period in February. It's performance over the long haul, after digesting a firm's competitive advantages, growth prospects, and profitability initiatives. Let's take a dive into what Wal-Mart (WMT) is really worth.
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Wal-Mart posts a Valuentum Buying Index score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm and its unattractive relative valuation versus peers. We compare Wal-Mart to peers Costco (COST), Target (TGT), and Walgreens (WAG).
Our Report on Wal-Mart
• Wal-Mart's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• Walmart International is the company's primary growth engine. With $125 billion in sales, its international business alone would be among the three largest retailers in the world. The company remains focused on expansion in Brazil and China.
• Wal-Mart's cash flow generation and financial leverage are at decent levels, in our opinion. The firm's free cash flow margin and debt-to-EBITDA metrics are about what we'd expect from an average firm in our coverage universe.
• We don't see Wal-Mart going away anytime soon. Though it faces pressure from both Amazon and discount dollar stores, consumers continue to flock to its locations. Its everyday low prices strategy has revolutionized the industry.
• The firm sports a very nice dividend yield of 2.3%. We expect the firm to pay out about 32% of next year's earnings to shareholders as dividends.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Wal-Mart's 3-year historical return on invested capital (without goodwill) is 17.4%, which is above the estimate of its cost of capital of 9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Wal-Mart's free cash flow margin has averaged about 2.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Wal-Mart, cash flow from operations decreased about 8% from levels registered two years ago, while capital expenditures expanded about 11% over the same time period.
Our discounted cash flow model indicates that Wal-Mart's shares are worth between $57.00 - $85.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $71 per share represents a price-to earnings (P/E) ratio of about 15.6 times last year's earnings and an implied EV/EBITDA multiple of about 8.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 3.3%. Our model reflects a 5-year projected average operating margin of 6%, which is above Wal- Mart's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For Wal-Mart, we use a 9% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $71 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Wal-Mart. We think the firm is attractive below $57 per share (the green line), but quite expensive above $85 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Wal-Mart's fair value at this point in time to be about $71 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Wal-Mart's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $88 per share in Year 3 represents our existing fair value per share of $71 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements