### Is WalMart Wildly Undervalued?

May 01, 2010
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Of the many investment books I have read, one of the ones that had the biggest impact on me was Hagstrom's "The Warren Buffett Way," originally published in 1994. It tells the story of Buffett's career up to that time, and explains some of the stock investments that made him so very wealthy. Today, on the day of the Berkshire annual shareholder's meeting, is a good day to revisit it. This book also describes Buffett's investment tenets:

Business Tenets: 1) is the business simple and understandable?; 2) Does the business have a consistent operating history?; 3) does the business have favorable long-term prospects?.

Management Tenets: 1) is management rational?; 2) candid?; 3) does it resist the "institutional impulse" in favor of efficiency on a day-to-day basis?

Financial Tenets: 1) focus on return on equity, not earnings per share; 2) calculate owner earings (free cash flow); 3) look for a high profit margin; 4) for every dollar in retained earnings, look for more than one dollar of market value.

Market Tenets: 1) what is the market value of the business?; 2) can the business be purchased at a significant discount to its value?

In this post, I will attempt to apply one of the market tenets, valuation of a business, via discounted free cash flow, to Wal-Mart. Wal-Mart is presently one of my top five holdings, but this is not an attempt justify my prior decision. This is an attempt to clarify my rationale, and to test it. What I REALLY hope is that some other investors on this site with more experience and intelligence than I have will come in and tell me what I am missing.

Discounted "Owner Earnings"/Free Cash Flow:

This is a key Buffett method for valuing a company. Owner Earnings = Net income + Depreciation + depletion & amortization - capital expenditures - additional needed working capital. Another, more common, term for this metric is Free Cash Flow. One way to calculate the value of a company is to determine the present value of all future cash flows of a company. Buffett only looks at very solid, dependable companies he understands, with predictable track records, becasue it makes the future somewhat easier to predict. It seems to me that if one runs a discounted "Owner Earnings"/Free Cash Flow ("FCF") analysis for Walmart today, Walmart seems hugely undervalued, relative to its intrinsic value.

With the DFCF analysis, what you need are 1) an estimate growth rate of FCF, or a two-tier growth rate; and 2) a discount rate, to discount future cash flows to present value. If you assume you are dealing with a predictable company, as Buffett does, you do not use a risk premium. I'll discuss the discount rate first. Buffett for many years used the 30-Year T-Bill. When Buffett valued Coke in the nineteen eighties, this was aroung 8 or 9%. Today it is sub-5%, but to be conservative, I will apply a discount rate of 8%. Today's long term T-bill rate is unsustainably low, and I am making the assumption that over the next ten years the rate will be more likely to average 8%. This seems like a conservative assumption because the higher the discount rate,the higher the cost of capital; this is the interest rate Walmart would have to pay to raise capital from investors. In reality, as of January 2010, Walmart's weighted-average effective interest rate on long-term debt was 4.5% (annual report, page 26), in part because Walmart enters into interest rate swaps. I'll come back to the discount rate in my calculation.

Turning to FCF growth, the only way to estimate future growth is to look at past growth. I like a ten-year period. Here is where it gets fun. From 2001 through 2010, Walmart grew FCF from $1.562 billion to $14.065 billion. That works out to a Compound Annual Growth Rate ("CAGR") of 24.58%. That is truly massive annualized free cash flow growth over the past ten years, particularly for such a large company. For the sake of comparison, Microsoft, a highly profitable company, which I also own shares in, grew FCF from 2001 to 2009 at a CAGR of **less than 5%.** So if I thought that Walmart were capable of growing FCF at a 24%+ annualized clip for even the next ten years, then I would truly be salivating. Unfortunately, if you look at Walmart's most recent years, you see that a significant amount of growth in FCF took place in the last two years. As recently as 2008, FCF was only $5.417 billion, meaning that from 2001 to 2008 FCF only grew at a CAGR of 13.24%, still not terribly shabby, but nowhere near 24.58%! According to Walmart's 2010 Annual Report, at page 20, the increase in FCF in 2009/2010 was "primarily the result of improved operating results and inventory management."

If you dig into the numbers, a lot of it is the result of improved inventory management. Specifically, from page 33 of the annual report, Walmart achieved a large $2.265 billion decrease in inventories, which is recorded as a positive. Walmart also an increase in accounts payable of over $1 billion, also accounted as a positive. As Walmart notes on page 5 of the annual report "[i]mproved productivity through enhanced scheduling systems better matched associate staffing levels in our stores to customer traffic. Stronger supply chain processes also improved inventory f low. Merchandising and planning systems contributed to lower inventory levels, which were also benefited by increased sell-through." Indeed. Nonetheless it is in my view improper to credit Walmart with a full 24.58% CAGR on FCF given the reasons for its growth between 2008 and 2010. Additionally, Walmart experienced significant drops in FCF in 2005 and 2006. What growth rate to give it then over the next ten years? What rate of perpetuity growth? Let's try a few.

I like to do a two-part DFCF analyisis that assumes a set rate of higher growth over the upcoming ten years, and which then assumes a much lower rate of growth subsequently, in perpetuity. Obviously a number of assumptions are impbedded within that analyiss. First, I am assuming I have a decent grasp on what will happen in the next ten years. I think this is a reasonable assumption if I am looking at a very safe, low-debt, well-managed company with consistent FCF growth. Second, I am assuming I cannot know what will happen in the long term. But third, I am assuming that a well-managed company should at least be able to grow FCF at the rate of population growth, which I modestly estimate at 1-2%. Thus, for my growth in perpetuity rate I use one of those two numbers.

As for FCF growth over the next ten years, I am going to start conservatively with 10% CAGR. That is less than half of what Walmart achieved from 2001 to 2010. It is also less than Walmart acheived from 2001-2008, before the massive increase of the last two years. So, if one assumes the starting FCF value as of 2010 of $14.065 billion, 10% CAGR of FCF for ten years, a conservative discount rate of 8%, subsequent perpetuity FCF growth of only 1%, and a constant number of shares (currently 3.76 billion), then I calculate the present intrinsic value of Walmart to be, as of today today, $64.97 dollars/share, on my fun little spreadsheet I created for DFCF analysis. As of Friday, shares traded for $53.64. That means that under what I feel is a very conservative analysis, Walmart shares are undervalued by 17.44%.

If one changes the CAGR of FCF over the next ten years to 13%, the rate Walmart achieved from 2001 to 2008 but one changes nothing else, the present intrinsic value of Walmart is $77.605/share, making Walmart stock currently undervalued by 30.88%.

If one assumes a perpetuity growth rate of 2%, then assuming a 10-year growth of 10% Walmart is worth $69.84/share, making it undervalued by 23.2%, and assuming a 10-year growth rate of 13% Walmart is worth $88.80/share, making it undervalued today by $35.99%.

If one wants to get funky and assume a FCF growth rate of 20% over the next ten years, with a rocking 3% growth rate in perpetuity after that, then Walmart is currently worth $128.63/share, making it 58.3% undervalued. Note, that is still assuming a discount rate of 8%. If one keeps those optimistic parameters, but sets the discount rate for the next ten years to 5% (which is still more than the current interest rate cost of Walmart's long term debt), then Walmart is worth $317.19/share today, and is undervalued by about 491%. (Heck, if you assume a 5% discount rate, then even if Walmart grows only 2% CAGR from NOW to perpetuity, it is worth $95.26/share, making it 43.69% undervalued.)

Finally, for Friday's share price to be accurately pricing the company, you may assume one of the following scenarios: 1) 5.594% 10-year CAGR in FCF, with a 8% discount rate, 2% perpetuity FCF growth; 2) negative 10-year CAGR in FCF, with a 5% discount rate, 2% CAGR perpetuity FCF growth thereafter.

I am aware that many, many other things go into valuing a stock. Walmart does not do as well on some of Buffett's other tenets. And this was more of an intellectual exercise than anything else. I will expand upon my analysis of Walmart in additional posts, where I will discuss profit margin, debt/equity, return on equity, return on retained earnings. I will also get into some comparisons with other companies, like Target, Costco, Safeway, BJ's Wholesale Club, Amazon, etc.

Let me leave with a few more notes though. Walmart has a consistent return on equity of over 20%, and its current 2010 ROE is 21%, with a debt/equity ratio of under .6. Target, which has higher total debt, equal to equity, only had a 2010 ROE of 16.2%. Also, while Walmart has thusly grown its FCF over the last ten years, its total short term debt has fallen, and its long term debt, while it has doubled nominally, is today a much lower percentage of equity/capitalization than it was ten years ago. Target's FCF growth is also nowhere near as consistent, and the large spike in TGT's FCF in 2010 was due to HALVING capital expenditures, i.e., cost-cutting, yes, but also reduced reinvestment in the business.

Walmart is in a commodity business. It has very little goodwill, in the non-balance-sheet, pricing-power sense (think: Apple, for the opposite sort of company, one to which people will pay hundreds of dollars more than cost for products that will make them look cool while they sit in a Starbucks or, just as often, in a local, small-business alternative to a Starbucks). The only reason to invest in a company without such goodwill is when it is the lowest-cost provider, the most efficient, the most ruthless at what it does, which is cut costs. In my next post I will turn to Costco and Amazon.com, which are in my instinctive view far worthier competitors than Target or (I shudder) K-Mart, though we shall se....