Last time we considered that Walmart market value has gone sideways for at least eight years. If we define owner earnings as the cash available for the benefit of equity owners either directly (e.g., payouts through dividends or share buybacks) or indirectly (e.g., reinvestment into profitable business growth), we can see that management has increased that from about $7 billion in 2003 to about $18 billion in the most recent full fiscal year. That's over 13% compounded annual growth.
All the while, the stock price has gone from a peak of nearly $64 in 2003 down to about $50 today for a compounded annual SHRINK rate of 3%. So, it's clear that the share price and the value of the company have been at a disconnect. How does that relationship look today?
On the basis of owner earnings, at $50 per share the company is …
1. Very cheap on an historical
basis. We saw this in the last post where Wal-Mart’s owner earnings multiple
has dropped each year from 40x in 2003 to about 10x now, making it the cheapest
it has been over the entire eight-year period.
2. Cheap to very cheap on a
relative basis. Based on my rough estimates of owner earnings for some other
key retailers, Wal-Mart is trading below all of them. Home Depot is currently
valued around 15x owner earnings, Costco about 27x, Dollar General is 14x, and
Target is 9x.
3. Pretty cheap on an absolute
basis. 10x owner earnings implies that Wal-Mart produces a 10% yield for the
benefit of owners based on the price they would pay to own its stock
today. For my tastes, screaming cheap for a good company about 15% yield (~7x),
but for great companies with strong prospects I can stomach as high as 20x
owner earnings (5% yield).
All modes of cheap, however, are not created equal. It makes me think of the quip attributed to Woody Allen, "Just because I'm paranoid doesn't mean they're not after me." A business can appear cheap on a variety of measures and, more likely than not, it's cheap because it's legitimately not worth more than its price. There is a special danger inherent to making comparisons when trying to establish the value of a business, whether you're comparing it to itself (historical) or to similar companies (relative). Perhaps it appears cheap because it has exhausted all growth prospects that helped speculators rationalize its 40x valuation eight years ago. Or perhaps it ceded its competitive advantages to other retailers and now must fight in value-diminishing ways to maintain its market share. Reasons abound for cheap value matching cheap price.
That's not to suggest there is no benefit to reviewing historical or relative measures of cheap, but they must be steeped in two additional thought processes to make sure they aren't just leading you into a value trap.
The first is a relatively simple question you can ask yourself and treat it like a point on a safety check-list: Is the business cheap on an ABSOLUTE basis?
The full implications of that question are more complex than the check-list concept might suggest. It's largely a measure of placing the business in a state of suspended animation - taking a snapshot of where it stands today - and evaluating it as if it were an interest bearing investment. Take owner earnings, compare them to the price at which you're buying the business, and equate the percentage to interest paid against your principle investment. If the rate satisfies your return requirements, you can check the box.
For example, with Walmart trading at 10x owner earnings we can say that buying the business for $50 yields you $5 in earnings. If you return requirements are 10% or less, you have satisfied that checklist item.
Hypothetically, you could stop here if you had good reason to believe Walmart will continue operating in AT LEAST as good a state as it currently exists. You can say it's cheap on an absolute basis. But investing is rarely that simple. The second thought process can take you deep down the rabbit hole...
What does the future hold for this business?
The essence of investing is divining the future. Even if you're trying to check the simple box of whether a business is cheap on an absolute basis, you're making implicit assumptions that the business will continue generating the same amount of owner earnings into the future. That assumption requires further assumptions about access to and use of capital, competitive landscape, size of the market, etc. in what can seem a forever branching sequence of questions and even more assumptions. I'll avoid any attempt at the discussion here, but it's no stretch - when considering how variable A affects variable B changes variable C, ad infinitum - to say a business is akin to a chaotic system (using the physics definition) in which specific outcomes (the future) are by definition unpredictable and therefore unknowable. You will get it right from time-to-time, and perhaps even more often than not. But unless you have a reliable process for approaching it, you have no basis of saying your success (or lack thereof) is based on anything more than pure chance.
What is a reliable process for attempting to divine the future? One that confesses extreme ignorance of precise outcomes and gears itself instead to avoiding big mistakes. One that looks for advantages and still makes conservative estimates of future performance. One that eschews lazy-minded optimism in favor of a wide margin of safety.
Next, we'll discuss a way to think through margin of safety in valuing Walmart.
All modes of cheap, however, are not created equal. It makes me think of the quip attributed to Woody Allen, "Just because I'm paranoid doesn't mean they're not after me." A business can appear cheap on a variety of measures and, more likely than not, it's cheap because it's legitimately not worth more than its price. There is a special danger inherent to making comparisons when trying to establish the value of a business, whether you're comparing it to itself (historical) or to similar companies (relative). Perhaps it appears cheap because it has exhausted all growth prospects that helped speculators rationalize its 40x valuation eight years ago. Or perhaps it ceded its competitive advantages to other retailers and now must fight in value-diminishing ways to maintain its market share. Reasons abound for cheap value matching cheap price.That's not to suggest there is no benefit to reviewing historical or relative measures of cheap, but they must be steeped in two additional thought processes to make sure they aren't just leading you into a value trap.
The first is a relatively simple question you can ask yourself and treat it like a point on a safety check-list: Is the business cheap on an ABSOLUTE basis?
The full implications of that question are more complex than the check-list concept might suggest. It's largely a measure of placing the business in a state of suspended animation - taking a snapshot of where it stands today - and evaluating it as if it were an interest bearing investment. Take owner earnings, compare them to the price at which you're buying the business, and equate the percentage to interest paid against your principle investment. If the rate satisfies your return requirements, you can check the box.
For example, with Walmart trading at 10x owner earnings we can say that buying the business for $50 yields you $5 in earnings. If you return requirements are 10% or less, you have satisfied that checklist item.
Hypothetically, you could stop here if you had good reason to believe Walmart will continue operating in AT LEAST as good a state as it currently exists. You can say it's cheap on an absolute basis. But investing is rarely that simple. The second thought process can take you deep down the rabbit hole...
What does the future hold for this business?
The essence of investing is divining the future. Even if you're trying to check the simple box of whether a business is cheap on an absolute basis, you're making implicit assumptions that the business will continue generating the same amount of owner earnings into the future. That assumption requires further assumptions about access to and use of capital, competitive landscape, size of the market, etc. in what can seem a forever branching sequence of questions and even more assumptions. I'll avoid any attempt at the discussion here, but it's no stretch - when considering how variable A affects variable B changes variable C, ad infinitum - to say a business is akin to a chaotic system (using the physics definition) in which specific outcomes (the future) are by definition unpredictable and therefore unknowable. You will get it right from time-to-time, and perhaps even more often than not. But unless you have a reliable process for approaching it, you have no basis of saying your success (or lack thereof) is based on anything more than pure chance.
What is a reliable process for attempting to divine the future? One that confesses extreme ignorance of precise outcomes and gears itself instead to avoiding big mistakes. One that looks for advantages and still makes conservative estimates of future performance. One that eschews lazy-minded optimism in favor of a wide margin of safety.
Next, we'll discuss a way to think through margin of safety in valuing Walmart.
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