Wal-Mart's Required Business Performance Deceptively Low?

Currently the median Required Business Performance (RBP) probability of the 750 stocks in the Dow Jones U.S. Large-Cap Index is around 75%. This is very high, but significantly lower than it was several months ago. It means, simply, that the typical large cap company has a 75% probability of producing the results implied by the current price of its stock. That is pretty good odds overall, but the best approach to investing in an uncertain market is to place your bets where this probability is maximized. Among the stocks in the RBP Portfolio, Wal-mart (WMT) was formerly one of the standouts in this regard. Today, its RBP Probability is much lower.

Last week Wal-mart released quarterly results that met the street’s expectations and forecast earnings that were also in line with consensus estimates. Nevertheless, WMT stock is down about 3.5% since then. Such declines sometimes create an opportunity, as the company’s Required Business Performance is now noticeably lower. To justify the company’s current stock price of $49.30, Wal-mart need only grow revenue at a rate of 3.2% per year for the next ten years (thereafter at 2% in perpetuity). This is a very low standard to which to hold the greatest growth stock in the history of retail.

Alas, Wal-mart is now a huge company and growth is more difficult, not to mention the state of the macroeconomy. Further, its recent history indicates that such a growth rate may be hard to maintain after all. Though the company has averaged sales growth of 7.4% over the past five years, in at least two recent twelve-month periods growth has been either negative or zero, including the most recent twelve months. Indeed, WMT’s RBP Probability is currently 66.5% (See WMT’s RBP Snapshot), indicating that there is only a 66.5% chance of it delivering this 3.2% growth. This figure is slightly lower than retailers in general.

Is such an RBP Probability too low? Can Wal-mart perform at a level of 3.2% sales growth or higher for a reasonable amount of time? There is plenty of reason to speculate it can. First, let me describe the assumptions behind the reverse discounted cash flow analysis that went in to the calculation of the company’s Required Business Performance and RBP Probability: Gross margin will remain a constant 24.7%, cost of capital is 7.4%, inventories as a percentage of cost of goods sold remain constant, capital expenditure growth of 4% in year one but declining slowly. Also. no unusual or one-time items.

Many investors have been speculating that Wal-mart will actually benefit from a sluggish economy as more shoppers trade down to discount merchandise from higher-end retailers. This theory was supported by the April-only sales growth numbers released a few weeks ago. U.S. same-store sales grew by 4% over April 2008, a rate even higher than previous months. This could indicate that as the economy continues to sour shoppers are increasingly replacing their favorite shopping venues with a much cheaper alternative. Consider that Nordstrom, for example, reported that April same-store sales declined by 10.8%.