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After a dissapointing quarter, many investors are looking to see if there's opportunity in Wal-Mart's (NYSE:WMT) stock. After an outstanding performance during the height of the recession, Wal-Mart was investors' retail darling. Now that the american consumer is back, Wal-Mart has seemingly taken a step back. Technically, the stock has been bouncing off its support, but fundamentally-- is the stock fairly priced?



As part of my study for the CFA level 2 curriculum, I reviewed various equity valuation models including dividend discount models, H-model, residual income models, free cash flow models and market-based valuations.

The two key inputs to any valuation is the discount rate and the growth rate. The discount rates were computed using the build-up method. The build-up method involves adding the comp bond yield curve with the firm's equity risk premium. For unavailable maturities, the yield was interpolated from the closest bonds.

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Dividend Discount Model Valuations

Typically, dividend discount models are used for mature companies like Wal-Mart. However, 1 year and 5 year dividend growth rates have been in the low teens, and thus, the one stage model would not be applicable. Instead, the two stage dividend model, or 'H-model,' which smooths out short term growth to long term growth.

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Free Cash Flow Model

The most well known fundamental valuation model is the discounted cash flow model which discounts future free cash flow estimates to present value. This model works well for companies with positive free cash flow, regardless of dividend policies or capital structure, and for investors that have significant stakes. Analysts need to be careful before using the free cash flow model as there needs to be an economic relationship between company performance and free cash flow growth. Using the aforementioned discount rates, the 30-year free cash flow model price is $50.08 while the terminal value is $56.72.

Residual Income Model

The residual income model values companies based upon their return on equity over the investor's cost of capital. This valuation model focuses on management's capital efficiency and investment decisions. Residual income is measured by the difference between net operating profit after tax (NOPAT) minus (Invested Capital * WACC). The present value of the company's residual income over the investor's time horizon plus the current book value equals the model price. The advantage of this model is that it could be used for companies with no dividends and negative free cash flow. The disadvantage is that it requires in depth analysis into the accounting accruals. The residual income model at 3% earnings growth gives a model price of $51.75, close to Wal-Mart's closing price of $52.06.

Compareable Company Analysis

Relative pricing is a popular valuation methodology that involves taking competitors' multiples and applying them to the financials of the company in question. For example, the industry's multiples P/E, P/S, P/B, P/Cash are averaged and multiplied by Wal-Mart's earnings per share, sales per share, book value per share and cash per share.

Below are images that show Wal-Mart's competitive landscape, and the implied valuation ranges in table and graphical formats. Competitive landscape includes, Target (NYSE:TGT), Costco (NASDAQ:COST), BJ's Wholesale (NYSE:BJ), Big Lots Inc. (NYSE:BIG), Dollar Tree (NASDAQ:DLTR), Family Dollar (FD) and Dollar General (NYSE:DG).

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Valuation Summary

The boxes below summarize all of the model prices, the average valuation and the corresponding market mis-pricing. As indicated, Wal-Mart is fairly priced. The model's valuation assumed a company growth rate of 3% and an equity risk premium of 3%. If you disagree with the figures, the valuation matrix provides the corresponding valuations for those assumptions.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Wal-Mart Is Fairly Priced