Wal-Mart Stores is a dividend aristocrat, having raised its dividend for 37 consecutive years. From Wal-Mart's recent 10-k:
Wal-Mart Stores, Inc. (WMT) operates retail stores in three business segments: Walmart U.S., Walmart International and Sam's Club. During the fiscal year ended January 31, 2011, the Walmart U.S. segment accounted for 62.1% of its net sales, and operated retail stores in different formats in the United States and Puerto Rico, as well as Walmart's online retail operations, walmart.com. The International segment consists of retail operations in 14 countries and generated 26.1% of the Company's net sales. The Sam's Club segment consists of membership warehouse clubs in the United States and Puerto Rico, and the segment's online retail operations, samsclub.com, and accounted for 11.8% of the Company's net sales.
A 10-year summary of Sales, Earnings Before Interest and Tax (EBIT), Earnings per share (EPS), yearly high and low stock price, corresponding high and low P/E (calculated by dividing the high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below.
Key 10-year data for Wal-Mart Stores
Sales (in Billions)
EBIT (in Billions)
From these data points, we can plot Sales, EBIT, and EPS versus Year, as shown in the chart below.
Sales (in Billions), EBIT (in Billions), and EPS versus Year for Wal-Mart Stores, 2002-2011
As evident from the chart above, Wal-Mart has demonstrated very predictable sales and earnings over the past 10 years (with R squared greater than 0.95), the mark of a great company. This allows us to predict EPS in the near future, say in five years (i.e. Year 2016), using the logarithmic regression equation for EPS = 3.02E-105 * exp(0.11*Year) = 9.21. This projection assumes 11% annual EPS growth.
A conservative average P/E estimate for the stock can be obtained as follows:
Signature P/E: A well established stock has a signature P/E, an average P/E it commands in the market based on its business. We calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (data points that fall significantly beyond the other data points). The company's P/E has come down in the past 10 years; we can consider the P/Es from years 2001-2004 to be outliers, so we average the Average P/Es from the past six years to arrive at a signature P/E of 15.2.
High P/E estimate: A conservative high P/E estimate can be calculated by averaging the five lowest High P/Es of the 10 High P/Es from the past 10 years. Averaging the five lowest High P/Es from the past 10 years gives 16.4.
Low P/E estimate: A conservative low P/E estimate can be calculated by averaging the five lowest Low P/Es of the 10 High P/Es from the past 10 years. Averaging the five lowest Low P/Es from the past 10 years gives 13.1.
Average P/E estimate: This takes the average of the High P/E estimate and the Low P/E estimate, as calculated above, to give a conservative estimate of an average P/E for the stock we can expect. Averaging 16.4 and 13.1 gives us 14.75.
Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $9.21 * 14.75 = $135.84, which represents an annual stock price return of 22% from the current price = $62. When we add in the 2% dividend yield, the total return expected is 24% a year, which means an investment in Wal-Mart today is expected to double in three years.
Given a beta = 0.36 for Wal-Mart, a risk-free rate = 2% (using the yield on 10-year Treasury bond as a benchmark), and estimated risk premium of about 6% for the general stock market, we have a discount rate = 2% + 0.36*(6%) = 4.16%. Applying this discount rate of 4.16%, our projected price of $135.84 in five years translates to a target price = $111 in today's dollars. This is about 79% upside from the current price of $62, suggesting the stock is undervalued right now. For a good margin of safety, investors are well advised to buy only if the current price is at least 20% below the target price. The current price of $62 is 44% below the target price, offering plenty of margin for error.
What is the market's expectation of Wal-Mart's growth rate given its current market price of $62? Since stock price = dividend * (1 + growth rate) / (discount rate - growth rate), we have growth rate = ((stock price) * (discount rate) - dividend) / (stock price + dividend). Plugging in stock price = $62, dividend rate = $1.48, and discount rate = 4.16%, we get growth rate = 1.7%. This seems low, given that Wal-Mart has grown its revenue by 6%, its earnings by 6%, and its dividend by 15% a year over the past 5 years. This suggests the stock is currently undervalued. Low expectations bode well for the stock, because it makes it easier for the company to beat these expectations.
The intrinsic value of Wal-Mart can be estimated using a discounted cash flow model. The company's operating cash flow, capital expenditure, and free cash flow (difference between operating cash flow and capital expenditure) for the past 10 years is shown below. The figures are in millions of dollars.
Operating Cash Flow
Free Cash Flow
These data are plotted below. (Click to enlarge)
Note that the operating cash flows over the past 10 years fit very well a logarithmic regression, with R squared greater than 0.9. Thus, we can comfortably project operating cash flow over the next 5 years, using the logarithmic regression equation 3.02E-76 * exp(0.0915*Year). This assumes that operating cash flows grow at a rate of 9.15% a year over the next 5 years, a reasonable assumption.
Capital expenditures and free cash flows over the past 10 years, unfortunately, do not fit into logarithmic regression very well, with R squared much below 0.9. So we cannot project them into the future using data of the past 10 years. Fortunately, the capital expenditures over the past three years fit very well into a logarithmic regression model, with R squared greater than 0.9. So we can project capital expenditure over the next five years based on the data over the past three years, using the equation 5.73E-40 * exp(0.0496*Year). This assumes that capital expenditures grow at 4.96% a year over the next five years. This is a reasonable assumption as Wal-Mart is a mature company and should not need as much capital expenditures relative to its operating cash flows as it did in the past.
We have previously calculated a discount rate of 4.16%. The caveat is that this might be temporarily low due to low interest rates. For this analysis, let us apply a more conservative discount rate of 6%. Let us assume, further, that the company will grow at a terminal growth rate of 3% a year after five years. From the fiscal 2011 balance sheet, Wal-Mart had $7395 million cash, $43842 million debt, and 3515 million common shares outstanding. With these inputs, we get an intrinsic value of $208 per share. The results are shown below. Note that total DFCF is sum of discounted free cash flow from years 2012-2016. Residual value = (DFCF from Year 2017) * 1.03 / (1.06 - 1.03). Total EV (enterprise value) is the sum of the total DFCF and residual value. Adding back cash and subtracting debt, we get equity value. Dividing by shares outstanding gives us intrinsic value per share.
Operating Cash Flow
Free Cash Flow
Discounted FCF (DFCF)
This suggests Wal-Mart is significantly undervalued at $62, with 235% upside. The caveat is that discounted cash flow analysis is very sensitive to the inputs. If we merely change our discount rate from 6% to 8%, for example, the intrinsic value would drop to $119, in which case the stock is still undervalued. Changing the discount rate to 12%, however, would change the intrinsic value to $60, about the same as the current price.
Current P/E Compared with Signature P/E
The stock's current P/E should be compared with its signature P/E, since established stocks tend to revert back to their respective signature P/Es over the long term. The current EPS = 4.44, giving us a current P/E = 14. This is about 92% of the stock's signature P/E of 15.2, suggesting the stock is slightly undervalued right now. To provide some margin for error, we should look to buy when the current P/E is 80% or less of the stock's signature P/E, which means a buy price around $54.
Wal-Mart's P/E Compared with Competitors' P/Es
It is also helpful to compare Wal-Mart Stores' valuations with those of its competitors and peers in the discount variety stores industry. Current P/E and Forward P/E are tabulated below for the company and its competitors. Also tabulated are 5-year average net profit margins and return on capital (ROC) for the companies as well as for the industry they are in.
Wal-Mart Stores (WMT)
Costco Wholesale (COST)
Wal-Mart appears to sell at a slight premium to Target, but at a significant discount to Costco and to the industry as a whole. Moreover, Wal-Mart has better net margin and return on capital than Costco and the industry, so it appears to offer good value on a relative basis. Although Target sells at a slight discount to Wal-Mart, and also has better net margin, its return on capital is inferior to both Wal-Mart and to the industry as a whole, so its relatively low P/E is probably justified.
Lastly, we calculate the Risk Index, calculated as (Current Price - Forecast Low Price)/ (Potential High Price - Forecast Low Price) to give an estimate of the risk/reward ratio. Risk index less than 20% is desired, which gives us +200% potential returns for every risk of 50% loss we assume.
The Forecast Low Price is calculated by multiplying the Low P/E estimate by the Forecast Low EPS, to give a conservative estimate of low price for the stock in five years, assuming zero EPS growth and low valuation. Forecast Low EPS is estimated by averaging the EPS over the past five years. For growth stocks with predictable earnings growth, EPS in five years should not be any lower than this conservative estimate. For Wal-Mart, the forecast low EPS is equal to 2.774, so the Forecast Low Price = 13.1 * 3.468 = $45.53.
The Potential High Price is calculated by multiplying the High P/E estimate by the projected EPS in five years, giving us a price target in five years should the stock command a high P/E. For WMT, this equals 16.4 * 9.21 = $150.76.
Thus, the Risk Index = ($62 - $45.53) / ($150.76 - $45.53) = 16%. Since this is below 20%, the stock has a favorable reward to risk ratio at the current price.
Wal-Mart Stores, Inc., currently selling around $62, has a target price of $111 and an intrinsic value of $208, suggesting the stock is undervalued. Upside potential appears to outweigh downside risk at the current price. Moreover, the stock compares favorably with its peers and the industry average in valuations. Its current P/E of 14 is also below its signature P/E of 15.2. Therefore, I rate the stock a BUY at the current price.
Disclaimer: Use this information as a starting point for your own due diligence, before buying any stock. If you do buy, be sure to read any annual reports (10-K) and quarterly reports (10-Q) to ensure that the fundamentals remain good and the stock is on target to reach its projected price. After holding for five years, repeat the analysis detailed in the article to decide whether to continue to hold, add, or reduce your position.