Smiley-Faced Value for Wal-Mart?

"Don't get emotional about stocks!"

In the film "Wall Street," Gordon Gekko, played by Michael Douglas, offers that advice to his protege -- wise words that Foolish investors should take to heart. But sometimes, as companies grow bigger and gain attention, they stir up controversy, making it hard not to get emotional. Wal-Mart (NYSE: WMT  ) is one particularly long-running example.

Everyone has an opinion about the company. We have the haters who blame it for allegedly driving smaller competitors out of business and paying low wages, and the lovers who welcome Wal-Mart's low prices and job creation. Bloggers throughout the web voice their stance on the company, and the media pinpoints every move it makes.

Look objectively
But let's put emotions aside and take an objective look at Wal-Mart as an investment idea. While the S&P 500 is down 5% over the last year, Wal-Mart has risen more than 13%, even as retail stocks in general are in a deep slump, and consumers are cutting their spending. Even the most optimistic economists agree that a recession is about to begin, if it hasn't already.

In this environment, Wal-Mart is back in its element. But this stock has basically traded sideways since 2000; it is really ready to make a move now? Or will it serve as a port in a storm for investors?

In 2000, the future was bright
First I want to dispel a few myths about Wal-Mart's lack of stock-price momentum the past seven years. The story is not that the company hasn't performed this decade, but rather that the company has never fulfilled the potential investors saw in 2000.

Back in 2000, the stock traded mostly in the mid-$50's, as it does today. But that represented roughly a trailing P/E of 42. Aggressive growth was on the menu, as only half of all domestic Wal-Mart stores had been converted to Supercenters by the end of the year. The smaller Neighborhood Market format was in its infancy (just 19 units), and international growth looked virtually unlimited. The world appeared to be Wal-Mart's oyster, ready to crack open and taste the juicy stuff inside.

But things didn't go as planned. The company has only expanded Neighborhood Markets at about 15 stores per year -- hardly the growth vehicle we originally assumed. Germany and Korea have been disasters, and domestic comparable-sales growth has slowed from 8% in 2000 to fewer than 2% in 2007. While EPS have more than doubled in seven years, Wal-Mart's earnings multiple has contracted at almost exactly the same rate -- hence a stock that has moved sideways. I would value Wal-Mart today on two criteria -- growth prospects, and a comparison to the best global brand companies.

Growth valuation
On the growth side, domestic business is easy to evaluate. Since 2000 Wal-Mart has added 4% each year to its U.S. store count. For the last three years comparable store sales have hovered between 2% to 3%, primarily because the company is as much a food and consumable company as anything else. Adding up store growth, comp sales, and a tad for operating leverage yields domestic earnings growth of around 8% to 9%.

International growth (particularly in China) is the wild card. International business is currently 24% of the company's worldwide sales. Excluding recent exits from Germany and South Korea, international business has grown about 20% the past two years. If that rate can continue, it would add about 3% to the domestic earnings pace, resulting in an expected consolidated earnings growth rate in the low-teens.

On that basis, I can get comfortable with a trailing-12-month PE for Wal-Mart in the upper teens -- faster than the expected growth rate, but appropriate for one of the world's leading retailers.

Comparative valuation
Here I turn to a financial brand power index. It isn't perfect (you could choose other metrics), but it gives a sense of how Wal-Mart stacks up against other leading companies worldwide that make or sell food and consumables.

TTM Sales
Growth

TTM
Operating
Margin

TTM
ROE

Total
Points

TTM
PE

Best Buy (NYSE:BBY)

11.4%

5.4%

26.3%

11

13.5

Walgreen (NYSE:WAG)

10.9%

5.8%

18.6%

11

17.9

Wal-Mart

8.6%

5.9%

20.4%

10

17.4

Target (NYSE:TGT)

6.5%

8.3%

18.4%

9

15.9

Costco (NASDAQ:COST)

8.8%

2.5%

13.4%

4

25.2

Data is for most recently completed fiscal year. Highest ranked company in each category earns five points. Lowest-ranked earns one point. Source is Yahoo! Finance.

The index is pretty simple. In each of the three financial metrics, it awards between one and five points to each company, based on its performance relative to the other companies on the list. By this comparative measure Wal-Mart also looks fairly valued. Best Buy at 13.5 times earnings appears undervalued, while Costco at 25.2 time earnings looks a bit overextended.  

So, after a seven-year spell in the doghouse, Wal-Mart appears to have achieved a valuation that makes good sense. And with the economy likely to remain sluggish for a while (putting a premium on companies that occupy the lowest cost space), I'd consider buying shares on dips.

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