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Wal-Mart Stores, Inc. (NYSE:WMT) is the largest retailer in the world, operating in several countries. The company's U.S. segment operates through discount stores, supercenters, as well as walmart.com. Wal-Mart International has additional retail channels, such as hypermarkets, restaurants, apparel stores, Sam's Clubs, and other online retail centers.

With more than $400 billion of annual revenues, Wal-Mart has an unmatched scale in the retail business. The brand image combined with the large economies of scale offers Wal-Mart a great competitive edge over relatively smaller retailers. The company has posted an annual earnings growth of about 9.2% in the past 5 years. The stock also returned about 50% since its dip in 2009.

Wal-Mart started to receive substantial attention recently, as its stock entered overbought territory. As of the time of writing, Wal-Mart stock was trading at $66 with a 52-week range of $48-$66. Thus, it made it new highs amidst the downturn in equity markets. It has a market cap of $222.8 billion. Trailing twelve month ((ttm)) P/E ratio is 14.1, and forward P/E ratio is 12.3 P/B, P/S, and P/CF ratios stand at 3.2, 0.5, and 8.2, respectively. Operating margin is 5.9%, and net profit margin is 3.5%. The company has some debt issues. Debt/equity ratio is 0.7, slightly above the industry average. Wal-Mart is an okay dividend payer. Based on the latest dividend of $0.3975, projected yield is 2.4%.

Wal-Mart has only a 2-star rating from Morningstar. Out of 5 analysts covering the company, 1 has buy, 3 have hold, and 1 has sell ratings. Wall Street has diverse opinions on Wal-Mart's future. Average five-year annualized growth forecast estimate is 11.1%. This seems like a reasonable estimate, given the company's past 5-year growth record of 9.2%.

What is the fair value of Wal-Mart given the forecast estimates? We can estimate Wal-Mart's fair value using discounted earnings plus equity model as follows.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.

E0 = EPS = ($4.66 + $5.34) / 2 = $5.00

Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 11.1%. Book value per share is $20.31. The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$5.00

V (t=1)

E0 (1+g)/(1+r)

$5.00

V (t=2)

E0((1+g)/(1+r))2

$5.01

V (t=3)

E0((1+g)/(1+r))3

$5.01

V (t=4)

E0((1+g)/(1+r))4

$5.02

V (t=5)

E0((1+g)/(1+r))5

$5.02

Disposal Value

E0(1+g)5/[r(1+r)5]

$45.66

Book Value

BV

$20.31

Fair Value Range

Lower Boundary

$76

Upper Boundary

$96

Minimum Potential

16%

Maximum Potential

46%

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Wal-Mart is between $76 and $96 per share. At the current valuation, Wal-Mart is undervalued. The stock has at least 16% more upside potential to reach my fair valuation range.

Click to emlarge

WMT Chart

WMT data by YCharts

Summary

Looking at the graph above, one can see that the Wal-Mart stock performed pretty well in the last month, returning almost 12.4% in May. I still think the stock has still substantial upside potential. The stock offers good value for the money.

Even after making substantial returns, the stocks in the traditional retail sector are vastly undervalued. Competitor's such as Target (NYSE:TGT), and Costco (NASDAQ:COST) are also trading at attractive ratios. Target has a forward P/E ratio of 11.77. Costco's P/S ratio of 0.4 is even lower than that of Wal-Mart. Among the retail discount stores, only Dollar General (NYSE:DG) seems to be slightly overpriced with a trailing P/E ratio of 21. However, considering the company's past earnings growth history, the premium price is well-justified.

Morningstar claims that the "bifurcated consumer recovery does not bode well for Wal-Mart's domestic top line". However, I do not agree with it. Wal-Mart does not cater exclusively to lower-income households. Maybe, its brand image in the U.S. is not really high, but it offers everything for everybody. If you can't find something in Wal-Mart (in store or online), then you have to search really hard to find. The company is also testing a smaller store format for neighborhoods, and that might prove to be a huge profit booster for the long term. Besides the regular dividend checks, this is another reason to consider Wal-Mart for the long term.

Source: Wal-Mart: At Least 16% Upside Potential