Sunday, 18 October 2015

More on Walmart and the Problem with DCF's

I've been thinking about my last post and wanted to follow up with more than just an off the cuff analysis.

First, I want to pay lip service to the importance of not just blindly using a DCF calculator in order to justify a fair value (and a resulting purchase). The more I read up on great value investors, the more I think that DCF must be approached with a high degree of extreme conservatism.

Case in point, here's Walmart straight off of gurufocus' DCF calculator page, using gurufocus' default growth parameters of 8% growth in eps over the next 10 years, and 4% terminally:














Pretty enticing!  5% margin of safety, stock trading $4 below "fair value", conservative discount rate of 12%, what could possibly go wrong?

Well, first, there is very little conservatism in estimating growth in eps over the next decade at 8% I'm not saying it's impossible mind you, heck, all Walmart would need to do is maintain current earnings and reduce the share count by 240M shares per year, et voila, 8% growth. Apologies for the quick math, current eps = $4.79 x (1.08) = 5.17 next fiscal.  In order to get there, they either grow earnings from $15.5B x 1.08 = 16.8B / 3,243 = $5.17, or they have zero growth in earnings, but buy back 240M shares; $15.5B / (3,243 - 240) = $5.17.  I can't even begin to guess what rate they'll grow organic eps at next year, let alone 10 years into the future.

Second, eps growth is not free cash flow growth.

Third, even if G = 8%, 4% was the "right" combination, shouldn't investors demand more than just a 5% margin of safety?  I would think that highly successful value investors (of which I am not), would want more than just 5%.

I personally believe that in order to map out a probable set of theoretical margins of safety, an investor needs to temper his/her expectations and run sensitivities across different combinations of growth rates, by modelling margin of safety at the worst possible G = i,j, Re = ?.  If there is a theoretical margin of safety using little to no growth v.s current price, then any upside in actual growth should translate into the valuation gap closing.

The problem with synthesizing any of this in real time is the emotion/ego attached to wanting to own the stock just because it's down from it's all time high.  The logic goes something like this:

"Investors paid close to $90 earlier this year and it's now $60.  It must be on sale, therefore I must own it".  But is it on sale at $60?

Here's Walmart again using gurufocus G = 3, 1%:















Completely different picture right?  All of a sudden, there is no theoretical margin of safety.  A patient value investor would probably want to buy in the mid to low $30's for a 20% margin of safety if fair value was indeed $43.36.

So why does G = 3%,1% make more intuitive sense than G = 8%, 4%?  For one thing, Walmart is already massive.  They had close to $500B in sales in 2014.  I hate to bring this up, but Amazon had $89B in sales (only)...if the Amazon/Walmart comparisons hold any weight, Amazon has a lot of catching up to do in terms of $1 for $1 Walmart sales.

I would hazard a layperson's guess that the majority of expansive growth is behind them, and go forward growth is likely a function of population growth from here on in.

Here's the annual change in US total population since the mid 1950's, courtesy of the WSJ:



















Here's the growth over the same period:





















We've got a total change in US population annually of somewhere between 2 & 2.5% and total growth of around 1%.  Maybe these should become my base case sensitivities for G = i,j in determining the worst case scenario for Walmart.  Amazon for the most part, likely has less dependency on population growth or change: it's a truly global entity available to the world's shopping tendencies at the push of a button, 24/7 (doesn't mean that this isn't factored into the stock price though).

I ran my own FCF DCF's through my own valuation matrices, one perpetual, the other two stage, and I came up with the following:


First, perpetual (i.e., I'm treating average free cash flows over the last three years as a perpetuity):


1/31/20131/31/20141/31/2015
FCF per 10K12,700.0010,100.0016,400.00
Add/Deduct:
Restructuring charges0.000.000.00
Def'd tax0.000.000.00
Gain on sale0.000.000.00
Normalized net income12,700.0010,100.0016,400.00
Add:
Depreciation0.000.000.00
Less:
FCInv0.000.000.00
Normalized FCF12,700.0010,100.0016,400.0013,066.67Average
Net Debt42,472.00
Free cash flow matrixRe =
G = 8%9%10%11%12%15%
0%163,333145,185130,667118,788108,88987,111
1.00%188,533164,967146,637131,973119,97694,267
2%222,133190,400166,600148,089133,280102,523
2.50%243,515206,051178,578157,569140,982107,147
3%269,173224,311192,267168,233149,541112,156
3.50%300,533245,891208,062180,320159,106117,600
4%339,733271,787226,489194,133169,867123,539
4.50%390,133303,437248,267210,072182,062130,044
5%457,333343,000274,400228,667196,000137,200
Valuation matrix:
o/s shares3243
Re =
G = 8%9%10%11%12%15%Average
0%37.2731.6727.2023.5320.4813.7625.65
1.00%45.0437.7732.1227.6023.9015.9730.40
2.00%55.4045.6138.2832.5728.0018.5236.40
2.50%61.9950.4441.9735.4930.3819.9440.04
3.00%69.9056.0746.1938.7833.0221.4944.24
3.50%79.5762.7351.0642.5135.9623.1749.17
4.00%91.6670.7156.7446.7739.2825.0055.03
4.50%107.2080.4763.4651.6843.0427.0062.14
5.00%127.9392.6771.5257.4147.3429.2171.01
Average53.9244.3137.1531.5927.1517.94
Current58.8758.8758.8758.8758.8758.87


Next, two stage FCF DCF


2-Stage DCF
TWO STAGE DCF
Free Cash Flow13,066.67
SharesOut3,243.00
Net Long Term Debt42,472.00
DCF-IV-9.07
Sum of DFC'sRe =
G = 8%9%10%12%15%Average, growth, blended Re
0,037.2731.6727.2020.4813.7626.08
1,039.4832.1227.6320.8914.1426.85
2,147.6138.2332.5724.3216.3531.82
3,1.554.0642.1435.7026.4917.7835.23
4,261.6446.5739.2039.2019.3141.18
5,2.570.6651.6643.1543.1520.9545.91
6,381.5557.5647.6347.6322.7251.42
8,494.9664.5052.7737.5724.6354.88
Average, Re, blended growth60.9045.5638.2332.4718.70
Current58.8758.8758.8758.8758.87



I happen to think that the valuations are a bit too conservative (but this is not necessarily a bad thing). In 2015, Walmart had close to $16B in FCF (per their 10K).  $16B less current initiatives get me back to $13B.  Once they spend their way through their current initiatives, and assuming the initiatives translate into positive NPV, there should be additional FCF to either pay out as additional dividends, or to use to buy back shares.  Here are the #'s modeled at $16B in FCF:

First, perpetual FCFs:


Valuation matrix:
o/s shares3243
Re =
G = 8%9%10%11%12%15%Average
0%48.5741.7236.2431.7628.0219.7934.35
1.00%58.0949.1942.2736.7332.2022.5040.16
2.00%70.7858.7949.8142.8237.2325.6147.51
2.50%78.8564.7054.3346.4040.1427.3651.96
3.00%88.5471.6059.5050.4243.3729.2557.11
3.50%100.3879.7565.4654.9946.9831.3163.14
4.00%115.1889.5272.4260.2051.0433.5570.32
4.50%134.21101.4880.6466.2255.6536.0179.03
5.00%159.58116.4190.5173.2460.9138.7189.89
Average68.9757.2048.4341.6336.1924.90
Current58.8758.8758.8758.8758.8758.87


Next, two stage FCF DCF



Sum of DFC'sRe =
G = 8%9%10%12%15%Average, growth, blended Re
0,048.5741.7236.2428.0219.7934.87
1,051.2842.2736.7728.5220.2535.82
2,161.2449.7642.8232.7222.9641.90
3,1.569.1354.5346.6535.3824.7146.08
4,278.4159.9750.9450.9426.5853.37
5,2.589.4666.2055.7755.7728.5959.16
6,3102.8073.4261.2661.2630.7665.90
8,4119.2181.9167.5648.9433.1070.15
Average, Re, blended growth77.5158.7249.7542.6925.84
Current58.8758.8758.8758.8758.87


I would hazard a guess that because Walmart is so widely followed (and widely owned), that the probability of it getting down to below $30 is likely remote, but certainly, at G = 3,1.5 (and above) and Re = 12%, $28 becomes compelling if FCF's post transition get back up to $16B.

I'm only pointing this out to demonstrate the realm of possibilities.  Anyone who's bought Walmart at $60+ has to be prepared for any eventually.













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