In this article, we're focusing on the appeal of Wal-Mart (NYSE:WMT) as an income stock. We appreciate that many investors buy Wal-Mart for its relative stability and in the hope of receiving a generous, growing dividend. However, with the S&P 500 at record highs, we think it's worthwhile to zero-in on Wal-Mart's income potential and valuation to see if it's still an attractive income play. We're also comparing it to Costco (NASDAQ:COST) to see how it stacks up to a GICS sector and sub-industry peer when it comes to making dividend payments to shareholders.
With the S&P 500 yielding just 1.9%, it's clear that investors are not going to have too many companies with top-notch yields available to them. So, while Wal-Mart's forward yield of 2.6% seems low in absolute terms, it's still 37% better than the index average. This means that, on a relative basis, Wal-Mart appears at first glance to be an attractive income play.
Indeed, its yield is considerably better than sub-industry peer, Costco, which has a forward yield of just 1.2%. If you were just looking at the two companies' forward yields (as many investors do), you would be very likely to buy Wal-Mart and avoid Costco, due to the difference in their forward yields.
However, we think there's much more to income stocks that just how high or low a yield they currently offer. For example, focusing on payout ratios highlights that Wal-Mart could be a whole lot more generous when it comes to making payments to shareholders. That's because it currently has a dividend payout ratio of just 39% which, in our view, seems very low. Sure, Wal-Mart needs to continually invest a proportion of profits within the business so as to replace plant and machinery, but we think that keeping 61% of profit each year is simply too high.
In fact, we think that Wal-Mart could easily afford to pay out 50% of profit as a dividend. Doing so could enable the company to reinvest sufficient capital, while also giving shareholders an income boost. Were Wal-Mart to have a payout ratio of 50%, its forward yield would increase to a far more attractive 3.3%. In fact, we think that a payout ratio closer to 60% is very realistic and could still strike a fair balance between shareholder payouts and reinvestment. A payout ratio of 60% would equate to a forward yield of 4%, which is clearly very attractive both on a relative and absolute basis.
It's a similar story with regard to Costco. It pays out even less profit as a dividend than Wal-Mart, with its payout ratio being just 29%. This goes some way to explaining why its forward dividend yield is lower than Wal-Mart's. Were its payout ratio to be the same as that of Wal-Mart (i.e., 39%), however, Wal-Mart would still have a superior forward yield of 2.6% versus 1.7% for Costco.
As well as having the scope to increase its payout ratio, Wal-Mart's dividends per share could also benefit from higher earnings. For example, the company is forecast to increase EPS by 4.1% in the current year to January 2015 and by 8.5% in the following year. Meanwhile, Costco has slightly better growth prospects than Wal-Mart, with its earnings due to rise by 12% in the year to August 2015. Clearly, both companies have the potential to increase dividends at a rate that easily beats inflation, which is a key consideration for income-seeking investors.
We're not surprised to see that Wal-Mart trades at a relatively low valuation. With a payout ratio of just 39% and an above average forward yield of 2.6%, it's clear that shares in the company are not exactly expensive. Indeed, Wal-Mart has a forward P/E of just 13.8, which is well below the S&P 500's forward P/E of 16.8 and represents even better value for money when compared to Costco's forward P/E of 23.5. It's a similar story when it comes to the EV/EBITDA ratio, with Wal-Mart's number being 8.2 and Costco's being much higher at 12.4. As a result, and despite its slightly lower EPS forecast growth rate for the next financial year, we think that Wal-Mart offers much better value for the money than Costco.
Although a 2.6% forward yield doesn't sound too impressive, we think that Wal-Mart and, to a lesser extent, Costco have huge potential as income stocks. Wal-Mart pays out just 39% of profit as a dividend, while Costco's figure is even lower at 29%. We feel that these numbers are simply too low and, for example, in Wal-Mart's case a payout ratio of 60% could mean shares in the company yield as much as 4%.
Furthermore, Wal-Mart has strong EPS growth forecasts that should allow the company, even if it maintains its current payout ratio, to keep dividend per share growth ahead of inflation. The same is true of Costco, although as a result of Wal-Mart having a far lower valuation, we think that it is the more attractive of the two companies for income-seeking investors.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.