Wal-Mart 1990 Case Study Intro and EPV(Part 1/2)

by hihih222

Walmart Case Study 1990-1991

This exercise is part of the Deliberate Practice challenge created by Whopper Investments. Here’s a link to the case study page. I’m going to start by giving you my notes as I read through the annual report and end with an EPV valuation of the company. Then, next time I’ll try to be back with a valuation of the company under a different framework. We’ll see how it all works out.

Notes:  This is the unorganized part. Here I am giving my thoughts as they come as I read through the annual report.

The first thing I see is clear, consistent growth for the last 10 years. This is a sign of a strong business, Clearly benefitting economically from either a competitive advantage or lack of competition b/c of new entry. More than likely since this is just retailing, Wal-Mart has a competitive advantage in this area as even the advantage of new entry shouldn’t last for 10 years and running without erosion.

Store Growth: Added 18 sam’s wholesale club stores(17% growth) to a total of 123 and Added 143 Walmart stores(11% growth) to a total of 1402. So Sam’s Club is growing faster, and it appears to be more than pulling its weight as we see that it makes up 8% of stores and 20% of sales…

What’s the Competitive Advantage then? Is this growth to be trusted?

MOTTO: Always low price on brands you can trust…..how do they get low prices? cost advantage?—maybe an edge w/ suppliers?

—In MD&A they emphasize that Sams and Walmart are both trending on reducing markons for prices to emphasize- “Everyday low prices”…THAT is the edge! Although it’s relatively weak unless they have an unusually high amount of turnover or a way to get supplies cheaper….

-In the time I would look at competition to see their turnover rates.

-As of now, I don’t see any reason they get supplies cheaper…in any case they have 22% gross margins which tells me they just have high turnover….(5x inventory turnover), and that ability to drive traffic is a nice consumer advantage. If they empty their inventory every 2-3 months, people go there a lot which means by force of habit they aren’t likely to change to a different retailer.

Track Record! 27th consecutive year of sales/earnings records and 15th consecutive year of ROE>30%….consistency in high returns of business, so clearly competition hasn’t been able to touch the business.

Anticipate 18% to 20% increase in retail square footage this year through increases in # of stores and expansions into new states w/ Walmart and Sam’s Club.

–Is this growth creating value? YES-ROIC is greater than Cost of Capital

            -Look at how past growth in square footage has paid off. How expensive is growth in square footage? What kind of returns are they getting? In past 9 years, they’ve added an avg of 120 walmarts per year….

Return on Invested Capital:

Consistent After tax ROIC of 19%(1B/(4.7-2.8+2.4+.9)=19.23%), so clearly returns are above cost of capital. Growth is creating value. In the last 3 years, Walmart has seen earnings growth north of 25% each year. Why? Addition of new stores, AND for old stores comps grew by 11% each year for last 3. Means the quality of the stores is high, and the value of growth is that much higher.

Breaking Down ROIC of Sam’s Club:

-Note, Management says gross margins were down a bit b/c of increase in Sams Club stores which have significantly lower gross margins than Wal-Mart because of “lower markon on purchases.”

-I think Sams might have some major growth potential as a discount retailer…Interesting to note that Sams Club’s expense ratios(SG&A) are significantly lower than Walmart’s….

Since Sam’s has significantly lower gross margins and significantly higher SG&A margins, we can assume Sam’s has net profit margins consistent w/ Walmart…

-Sams is 8% of total stores…assume that means 8% of total invested capital.

-w/ 4% net margins, Sams has 0.192B in net income.

-Sams Club’s After Tax ROIC= 0.192B/(5.2B*8%)=46% after tax ROIC =76% pre-tax ROIC!!!!

—NOTE: In the time I would go looking back at prior annual reports, try to figure out more about Sams Club’s business….is ROIC eroding? Growing? It seems their edge is just like WalMart’s(the have an even lower gross margin b/c of lower markons than Walmart).

                        -If provided more information, I would be convinced to look into breakup value of Wal-mart and Sams Club….what would be the value of a spinoff?


How do they drive profits? Low margins, high turnover…Costco type model but not as extreme. So low profits per revenue, but more revenue than competition…stealing market share? Something to look at if this was a modern example.

Appropriate Valuation Methods:

1)EPV(Asset Reproduction, EPV, Growth Breakdown)

2)Discounted Profits(DCF,etc)

3) Breakup Value(specifically because it has 2 profitable and growing businesses that have such a disparity in returns)

-Ability to do this depends a lot on the information available. Otherwise we make lots of assumptions about the characteristics of each company. If WMT had provided us with a more detailed breakdown of Sam’s Club’s net income so we could come up with a more accurate ROIC, I would believe that an analysis of breakup value would be more than merited.

1. EPV

Asset Reproduction Value:

Inventories: Notes: Inventory for this year is 4.42B, but says that replacement cost would be 0.3B higher for this year.

So I maintain value of current assets as the same but add 0.3B…Current Assets=5B.

I see nothing that implies value of land or property is higher than stated value, so I think Asset Reproduction Value is simply Assets+0.3B inventory value-2.8B current liabilities=5.7B….$10 per share.

I didn’t subtract out goodwill b/c it was so insignificant.I couldn’t find any way to quantify customer relationships, which would seem to be the real off balance sheet asset that would have to be reproduced. Also location seemed to be too difficult to come up with but that may have been understated as well…things to look for in other annual reports if I have them.

Earnings Power Value:

Calculating Normalized Non-Growth Earnings

  1. Adjust for one time charges or special charges
  2. Adjust for economic realities of company’s investment needs
  3. Adjust for cyclicality and other transient effects
  4. Adjust for any other problems necessary to find normal non-growth earnings
  1. I can’t identify any one time charges. There were none in 1990 and there were no asterisks or other signals in the 10 yr breakdown to indicate a one time charge in the last 10 years. This is something to keep an eye out for when reading older annual reports.
  2. Amortization of capital leases is a real cost b/c Walmart will have to renew those leases later, so I will only add back Depreciation, not Amortization. While they are together on the cash flow statement, the balance sheet shows a 50M increase in accumulated amortization from the last year.
    1. Add back Depreciation, Not Amortization

i.     +219M(add back to Net Income)

Calculate Maintenance Capital Expenditures

                                              i.     In Value Investing: From Graham to Buffett and Beyond, Greenwald suggests on pg. 96 in a footnote(always pays to read the footnotes) how one might go about finding Maintenance Capex.

                                            ii.     He suggests getting a ratio of PP&E to sales for the last 5 years and get the avg, which represents the dollars of PP&E needed to support each dollar of sales. Multiply this ratio by growth in sales for the current year and you get growth capex. Subtract growth capex from total capex to get maintenance capex.Works well if PP&E needed to support sales remains consistent.Lucky for us, all info necessary to do this is provided in the 1990 annual report.

iii. Ratio of PP&E to Sales(1990,1989,1988,1987,1986)=(0.132,0.129,0.134,0.140,0.154)

Avg:0.1378….roughly 14 cents of PP&E per dollar of sales.

Observation: Business has become less capital intensive over time…requires 15% less PP&E to get each dollar of sales than it did 5yrs ago.

 Growth in Sales(25.8B-20.6B=5.2B)*0.137=Growth Capex=0.712B

Capex(0.954B)-Growth Capex(0.712B)=Maintenance Capex of 0.242B(subtract from Net Income)

In this case, net income essentially approximates adjusted and normalized earnings power as depreciation accurately portrays the company’s maintenance expenditure needs.

3.    The business doesn’t appear to be greatly affected by cyclicality…it seems pretty recession resistant. In the last 10 years sales never declined…

4.    Also, there are no other costs to adjust for that I can see.

So, in conclusion, we’ve come full circle. For Wal-Mart, Net Income in the current year is the sustainable no growth income we’re looking for.

Calculating Cost of Capital

Total Capitalization=Long Term Debt+Long Term Current Debt+Equity

Equity is 94% of total capitalization. I’ll consider the effect of debt on cost of capital negligible.

Cost of Equity:

In Dec. 1990, risk free long term rates were at 8%. With such little debt and clear and easy to understand business, I don’t see it as very risky at all. The business has a plausible competitive advantage, so equity holders shouldn’t need to be paid much of a premium for the risk they take by buying WMT vs. a rf treasury bond. I’m using cost of capital of 11%.

Thoughts on Cost of Equity

Generally, an idea that I’m playing around with is that if debt makes up a significant part of the capitalization, cost of equity must always be higher than the cost of debt. So I think when coming up with a framework for cost of equity, here’s how I’m thinking through my minimum costs right now:

  1. Greater than risk free rate(opportunity cost and implied risk)
  2. Greater than cost of debt(equity have higher implied risk)
    1. Higher debt% of capitalization=higher cost of equity as equity becomes more and more risky….debt holders get first priority on capital.
    2. Greater than inflation(needs of equity investors are to preserve capital and create wealth. Preserve capital by having cost of equity higher than inflation).

Right now I’m still figuring out how to estimate cost of equity when it’s clearly significantly higher than risk free rates, but I know for sure I’m not satisfied by the academic CAPM method of calculating it.

Back to Valuation

Cost of Capital=11%.

EPV=Earnings*1/Cost of Capital

EPV=1.075B/.11=9.77B, or $17.26 per share.

Adding back cash and subtracting debt shaves 30 cents off for a value of $17/share.

The EPV substantiates the understanding of the no-growth version of the company I already have. The company’s ability to sell at “everyday low prices” has created a strong franchise. On its own, “everyday low prices” wouldn’t be enough to sell me on a franchise value almost double asset reproduction costs. I’m sure plenty of retailers at the time attempted this, but Wal-Mart’s 10 year financials speak for themselves. The franchise they’ve created and the superior returns they create over cost of capital has a value of roughly 4B on its own.

Valuing Growth

Walmart’s consistent history, however, is defined by consistent growth. Thus, we can easily expect this growth to continue into the future. Growth in sales roughly tracks growth in net income. In Greenwald’s valuation, since growth isn’t valued unless it stems from a competitive advantage, growth numbers imply a perpetual growth. For this reason, the growth % input can’t be too high, and the formula won’t even allow growth to be greater than or equal to cost of capital.

Walmart will be able to raise prices with inflation, so the worst sales could do is grow by 3-4% terminally. However, Wal-Mart has been growing sales a lot, by 25% this year, and this has been in part due to comparable store sales growth of 11%. That means that not only are new stores opening, but they’re improving. I see growth of at least 8% perpetually.

The Formula for Intrinsic Value of a Growing Firm

IV=Invested Capital*[(ROIC-Growth Rate)/(Cost of Capital-Growth Rate)]



IV=19.06B, or $33.67 per share.

Adding cash and subtracting debt subtracts 0.3, so Growth Value=$33.37

With market prices at around 26.5, I have roughly a 20% margin of safety WITH THE ASSUMPTIONS I MADE. However, I believe that Buffett saw a few things that changed the valuation of Walmart. First, he saw that cash flows were consistent and predictable, so using a discounted profit model(DCF,etc) would be perfectly acceptable. This would allow us to express a higher rate of growth in the next 10 years before the business slowed to a 6% growth pace. The fact is, with 25% growth this year with the addition of 60 stores and the addition of 200 stores planned for next year, growth is booming. Plus, both Walmart and Sams enjoy huge ROIC so growth is creating gigantic amounts of value. Understanding that this is the case, I think that the EPV method understates Walmart’s value. Second, if we assume that Walmart could grow at least at 10% perpetually, the value significantly changes(and since same store sales grew by 11% last year-excluding growth of stores-this isn’t absolutely unreasonable)….now we’re looking at a value over $100 per share!

-The thing with Walmart is that at conservative estimates of growth, margin of safety was roughly 20%…but intrinsic value is in a range, and it isn’t pushing it at all to say that perpetual growth could exceed 10%….8 years later we found out that was definitely understating it as Walmart’s share price(adjusted to the times) plateaued at about $180.

Lesson Learned? Explore all future scenarios and their probabilities. As WMT’s growth got infinitely closer to 11%, WMT’s value became infinitely higher. Therefore,  as I realized that I had a 20% margin of safety with 8% growth, I should’ve realized that growth any higher than that would create exponentially higher amounts of value and that with a brand like Walmart’s it wasn’t too unlikely that 10% perpetual growth could occur.

Another thing to consider is that with growth at 8%, that implied a P/E of 17. With growth at 10% perpetually, that implied a P/E of 60. So while Greenwald believed that EPV was able to solve the problem implied by the dramatic changes in terminal value in discounted cash flows, the problem wasn’t solved entirely through his EPV method, and while Greenwald’s implication in the book is that growth should be bought ONLY for free(the maximum buy price should be EPV), Wal-Mart would never have been available at EPV and even Warren Buffett admits it was a mistake to stop buying it when it was more than 33% higher than EPV.

I’m not going to stop here though. I still have a week until the challenge is over, so I’m going to go through and learn valuation as taught by McKinsey & Company in Valuation: Measuring and Managing the Value of Companies. I’ll be back in Part 2 with a valuation of the company as taught in that book. This way we can compare and contrast the methods and the assumptions backing them. I think I’ll benefit from the deliberate practice.