Despite growing competition in the discount retailing space, Wal-Mart's (NYSE:WMT) shares have performed relatively well, advancing to the high-$70s from about $60 per share at the start of 2012. Though we have no qualms with the resiliency of its equity in the face of a variety of challenges, the discount retailing giant did little to excite holders of its stock when it reported first-quarter results Thursday. For one, Wal-Mart's outlook for diluted earnings per share from continuing operations in the second quarter of its fiscal year, released during the report, came in below the consensus view, showing no progress versus the prior year. Let's see what that may mean with respect to our estimate of Wal-Mart's intrinsic value, and let's run the company through the Valuentum style of investing.
For those that may not know us, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Wal-Mart posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. Said differently, we think Wal-Mart's equity is priced about right, even as we give credit to the firm on the basis of its resilient technical and momentum indicators. Though a 6 is better than the score of the average firm in our coverage universe, we generally prefer firms that register a 9 or 10 (a "we'd consider buying" rating) on the Valuentum Buying Index. These companies not only have strong pricing support, but also have solid valuation support -- the best of both worlds. Many highly-rated firms we hold in the Best Ideas portfolio. With that said, let's dig a bit deeper into our analysis of Wal-Mart.
Wal-Mart's Investment Considerations
- 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. In Valuentum parlance, Wal-Mart has an Economic Castle, which considers the magnitude of a firm's future ROIC-less-WACC spread.
- Wal-Mart operates retail stores. Its Wal-Mart US segment includes the company's mass merchant concept in the US. Its Wal-Mart International segment consists of the company's operations outside of the US. The Sam's Club segment includes warehouse membership clubs and samsclub.com.
- 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 (NASDAQ:AMZN) and discount dollar stores, consumers continue to flock to its locations. Its everyday-low-prices strategy has revolutionized the industry.
- Wal-Mart 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.
- The firm has a solid dividend yield of 2.4%. Wal-Mart's Valuentum Dividend Cushion score, or a financial assessment of its future dividend coverage via a cash-flow and balance sheet assessment, is a comfortable 1.5 times.
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 with its weighted average cost of capital. 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 16.9%, which is above the estimate of its cost of capital of 8.9%. 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 2.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The retailer generates such a large revenue stream that its cash-flow conversion from sales is not as large as that of other firms in our coverage universe. 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 5% from levels registered two years ago, while capital expenditures fell about 3% over the same time period.
Our discounted cash flow model indicates that Wal-Mart's shares are worth between $61-$91 each. Shares are trading at roughly $77 at the time of this writing, roughly in the mid-point of this range. Though this may seem like a wide range for such a steady-eddy performer, all of the value of Wal-Mart (as in any equity) is based on the future (and we all know that the future is unpredictable). With competition intensifying both at the dollar-store level and at online powerhouses such as Amazon, we think the fair value range is reasonable. From a fundamental standpoint, 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 $76 per share represents a price-to-earnings (P/E) ratio of about 15.7 times last year's earnings and an implied EV/EBITDA multiple of about 8.3 times last year's EBITDA. Both of these multiples we deem as fair. Our model reflects a compound annual revenue growth rate of 3.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 4.1%. Our model reflects a 5-year projected average operating margin of 6.1%, which is above Wal-Mart's trailing 3-year average. We're modeling slightly lower top-line expansion than the most recently-completed three-year period as dollar-store and online competition heats up. That said, we are still modeling in significant e-commerce expansion at the retailing giant.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Wal-Mart, we use a 8.9% weighted average cost of capital to discount future free cash flows. We think the long-term assumptions are reasonable for such a large company as Wal-Mart. The discount rate we use to discount future free cash flows is meaningfully below the median within our coverage, but we think this appropriately captures Wal-Mart's lower-than-average risk profile. As you may have gathered up to this point, the retailing giant's most recently-reported quarterly results have little to do with calculating a cash-flow based intrinsic value estimate, which considers the trajectory of long-term fundamentals.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Wal-Mart to peers Costco (NASDAQ:COST) and Target (NYSE:TGT). Wal-Mart's price-earnings-to-growth ratio, which considers a future 5-year growth pace, is much higher than its peers, which offsets the firm's attractive forward price-to-earnings ratio. When combined, the PE and PEG ratios derive the company's neutral relative valuation assessment.
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 $76 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 $61 per share (the green line), but quite expensive above $91 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 $76 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 $94 per share in Year 3 represents our existing fair value per share of $76 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
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.