Valuing Wal-Mart
Assessment of Wal-Mart valuation using different methods To test the assumption of a discount rate of 7% as given in the outline of the case, we calculated the required rate of return for the Wal-Mart stock using CAPM . Using rWalMart = Rf + ? WalMart [E(RM) – RF], we find the required rate of return to be 7. 01% and in line with the information given in the case outline. Perpetual dividend growth model: The standard method of calculating a stock price using the perpetual dividend growth model is done by assessing a company’s dividend one year into the future adding the future expected growth rate.
The formula is written as: P0 = D1/(Ke ? g), where Ke is the investor required return, D1 is next year’s dividend and g is the expected growth rate of the dividend. The standard method can however be rearranged if the company analyzed is consider in “steady state”. A steady state implies that the annual return on equity equals the cost of equity capital providing the rational that the dividend payout ratio is the sole determinant of the dividend growth. It requires some complexity to determine if a company has reached steady state.
To investigate and analyze if Wal-Mart is in steady state, we would employ the following definition: Steady state value = free cash flow / discount rate . After careful consideration we have reached the conclusion that we find it fair and realistic to label Wal-Mart as such. This is further underlined by the maturity and stable performance of the company, which is illustrated in the stable revenue growth (exhibit 1), stable financial market stock data and relative stable dividend distribution (exhibit 3).
Further, we are comfortable using the simplified steady state formula given the foreseeable forecasting period as we are only forecasting the stock price a few years in the future and not conduction long-term multiyear forecasting where the underlying assumptions of the model and the competitive landscape can dramatically change. We find evidence that the forecast period is essential in the selection of method in the INSEAD article “Selecting an accounting-based Valuation Model” of May 2011. If we were to forecast long-term price levels, we would opt for the conventional formula of P0 = D1/(Ke-g).
Given the steady state nature of Wal-Mart we use the adjusted dividend growth model of: P0 = (E1 ? p)/ (Ke ? g), where g = (1-p)*Ke and where E1 is the earnings 1 year into the future and p is the payout ratio or the percentage of earnings paid in dividends. Using this method, P0 = (E1 ? p)/ (Ke – ((1-p)* Ke)), we estimate the stock price to be $58. 56 . For reference and to provide validation to our estimates, we have in addition estimated the stock price using the conventional dividend discount model of P0= (D1/(Ke-g). Using the conventional model we estimate the stock price to be $59. 8. We conclude that the estimated price of the stock is higher than the current market price of $53. 48 , which means we believe there is unrealized intrinsic value, hence the stock is undervalued and should we be analyzing the stock on this basis only, our recommendation would therefore be buy. Forecasted Dividend for the next 3 years plus future sale of the stock: Instead of valuing the stock with infinite dividend approach, we use a set number of years (3) plus we included the value of selling the stock after the set number of years.
The selling of the stock is represented in the model as a terminal value. The terminal value is the value of the company’s expected cash-flow beyond the forecast period. We estimate the terminal value by using the perpetuity method mentioned above and be employing the formula of Terminal Value (TV) = FCFt+1 / WACC . We used the approximation that WACC equals the required rate of return as found using CAPM (7. 01%, appendix 1). This also corresponds with the given discount rate of 7%.
As we are asked to find to price by forecasting dividends for the next three years plus the selling of the stock after year three, we have extrapolate our findings from the perpetuity method using the earnings per share with the given earnings per share growth and the required rate of return. By calculating the dividend per share until D=3 and employing: P0 = D1/(1+Ke)^1 + D2/(1+Ke)^2 + D3/(1+Ke)^3+TV/(1+Ke)^3, where TV is the terminal value we calculate the present day intrinsic value of the Wal-Mart stock to be $62. 15 hence the market value is consider low compared to our forecasted value.
This method replicates the basic foundation of the Discount Cash flow Model (DCF), which in our opinion is the preferred method in valuation studies. Three-Stage Approach: There are no questions about this approach in the outline of the assignment, so the following comments should be considered “back of an envelope” considerations. In general the three-stage approach allows us to add complexity to the standard dividend discount models by enabling changing growth scenarios throughout the forecasting period: an initial period of higher than normal growth, a transition/consolidation period of declining growth and final a period of stable growth.
The main assumptions are that the company on which we conduct the calculation study currently is in extraordinary strong growth phase. The time period with the extraordinary strong growth must be strictly defined and eventually be replaced with the declining growth assumption. Lastly, Capital Expenditures and Depreciation are expected to grow at the same rate as revenues. . Analyzing exhibit 4 we see a theoretical stock price of $120. 37. Using the excel template and by entering the calculated discount rate and the data given in the case, we find the theoretic value to be $95. 68.
We recognize the calculated theoretical value is considerable higher than the market value of the Wal-Mart stock, which could provide a strong indication for investing. However, we also recognize the weakness of the three-stage model thus we are careful to draw too decisive conclusion. We are especially concerned about the sensitivity and impact on the end theoretical price when making just marginal changes in the input factor. Valuation models in general are sensitive to the input factors, but we believe the extra complexity in the three-stage model amplifies even small forecast errors.
We understand that the three-stage model can be very useful for companies approaching the transition phase between growth phase and consolidation, but Wal-Mart does in our opinion not fulfill this characteristic. Thus, leading us to conclude the three-stage model isn’t particularly applicable to valuation studies of Wal-Mart. Price/Earnings multiple approach: The debate on whether to use trailing or projected price/earnings multiple is ongoing. We have found evidence in literature that there is no clear preference on which method to use as both have advantages and disadvantages .
We have no strong view or preference generally speaking, but in the case of Wal-Mart we believe there is a case for use trialing data rather than projected data. For reference we have calculated both using P0 = EPS * P/E . We see the range of estimates is very wide, which is due to the sensitivity of the input factors i. e. even small changes in the P/E-data will have significant influence on the estimated value at P0. We prefer to use the P/E multiple to assess how Wal-Mart is perceived and valuated against peers. In addition we use S&P500 as reference index and benchmark.
Using the data in exhibit 6, we have identified Wal-mart, Target, The Gap and Costco to be peers. We have concluded this after examining key financial data of all the companies provided in the exhibit. We realize that Wal-Mart is not directly comparable with the peers mentioned given the much larger market capitalization and turn-over, but knowing this a comparability study still adds value in our opinion. Detailed data of the comparison is brought in appendix 5. Looking at the graphical representation we see a clear trend in the peer group of declining P/E-ratios.
The trend is confirmed by further lower P/E-projections for the coming year. We are not overly concerned with the declining P/E ratios as it seems to be an industry wide trend and not isolated to Wal-Mart. Hence when assessing relative attractiveness of the grocery industry players, we do not see Wal-Mart having worse financial performance than the peers. As argued in the beginning of this paper in the section when discussing the steady state phase of Wal-Mart, we believe we can make a rough estimation of whether the P/E-ratio reflects a fair value of the stock or not. The method e employ is a rewritten method of the DDM. By arguing steady state we can also defend arguing Wal-Mart to be a zero growth company by assuming the company pays out all of its earnings in dividends. As we know from the data provided, this is not entirely reflecting the real scenario, however we still believe it adds value to the overall assessment of the value of the Wal-Mart stock. The rule of thumb argues that the P/E-ratio using the zero growth company assumption is fair when it equals the 1/r, where r is the discount rate meaning when Projected P/E = 1/r the P/E ratio is fair and reflects a fair value of the company.
Based on the research in this section we have found no red flags in the financial performance or when analyzing with peers. The historical P/E-ratio of Wal-Mart has been higher than the industry average so the decline over the time period can at first glance look dramatic. However, we believe the declining P/E-ratio is an industry wide tendency and not isolated to Wal-Mart. Further, given the strong P/E-growth in the early part of the data sample the Wal-Mart P/E-ratio is also subject to a strong base effect.
When applying the zero growth company fair value estimates, we see the projections made by the analysts are lower than the 1/r which we for this purpose consider a fair P/E, which can be seen as a supportive factor for the overall valuation of the Wal-Mart stock. Conclusion and recommendation: As indicated in the text above we have the most confidence in the first two methods in the paper. Taking a simple average of our findings we estimate the Wal-Mart stock price – or fair value – to be $60. 16 (58. 56; 59. 78; 62. 5), which is higher than the current stock price of $53. 48 hence we believe the Wal-Mart stock is $6. 68 or 12. 49% undervalued. Further, we find our estimates to be in line with the general analyst consensus target price of $60. 50. Given our findings and research we will recommend Gupta to buy the Wal-Mart stock. However, we recommend Gupta to employ a margin of safety. We recognize that our calculated price estimates have considerable projection risk given the future value is calculated based on estimates.
It is out of scope for this paper to evaluate the quality of the projections and forecasts, so we recommend Gupta to be conservative in communicating the price target. We suggest communicating the buy recommendation with an initial price target of $57. 75, which is +8% from the current market price. When the $57. 75 price is achieved we recommend running the models again to get validation on the $60. 16 price target. We recommend this step-by-step approach as margin of safety for projection inaccuracies. Given the time and year of the research done, we find further evidence that employing a margin of safety is a solid strategy.
This is especially due to the distressed situation of the financial markets after the collapse of the financial system starting in 2008. Given the unusual market situation any investments in stock or other financial instruments are subject to considerable risk from external factors, hereunder risk appetite, liquidity and macroeconomic developments, which currently are not properly factored in our price estimates. However, we are encouraged to invest in Wal-Mart given the defensive characteristics of the stock compared to the S&P500 benchmark given ?
