On Feb. 21, Wal-Mart Stores (NYSE: WMT ) will report earnings for the period that ended Jan. 31. Wal-Mart is the No. 1 corporation as ranked by Fortune 500 for the second year in a row, beating out ExxonMobil, and has been ranked first in eight of the past 10 years. The company, founded in 1945 by the late Sam Walton, has made countless "associates" and investors millionaires through the company's meteoric growth in its early years after going public in 1972. But since the late 1990s, the stock has been a laggard for investors seeking growth, meandering from a high of around $70 per share to a low in the mid-$40s. The stock is currently around $62.
How is quality of earnings analysis different?
The Motley Fool offers two databases -- EQ Scan and EQ Score -- that are used to uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. However, an investor's critical eye on these statements can often uncover mistakes or trends that could be important to understand before buying the stock.
When I review a company for earning quality, I assign an index rank to the company from 1 (the lowest quality ranking) to 5 (the highest quality) and an associated numerical score. As the company's financial status changes over time, I adjust its rank and score. I look for trends that affect earning quality.
Wal-Mart gets an earnings quality ranking of 1
The extent to which a company might manipulate revenue affects earnings and plays into the quality of earnings analysis, so let's briefly look at Wal-Mart's revenue history along with earnings per share. I added net income and average shares outstanding for better understanding.
2009 (in billions)
2010 (in billions)
2011 (in billions)
||$15,594 LTM (2011)
|EPS (fully diluted)
||$4.44 LTM (2011)
|Average shares outstanding
||3.506 LTM (2011)
Source: S&P Capital IQ. LTM = last 12 months.
Wal-Mart's earnings-per-share growth is based on reducing the float
Wal-Mart has averaged 3.55% revenue growth over the past three years compared to net income growth of 5.94% and EPS growth of 10.8%. How is this possible? Notice the decrease in average shares outstanding during this period from 3.951 billion shares in 2009 to 3.506 (2011 LTM) billion shares, or a 12.69% share reduction. Since earnings per share is calculated by dividing net income by outstanding shares, if we use the 3.951 billion shares from 2009 to calculate earnings per share in 2012, we get $3.94 EPS (estimated), or a growth rate of 5.94% -- the same growth rate as net income.
A large amount of Wal-Mart's yearly growth occurs during the January reporting period
On average, analysts expect Wal-Mart to report earnings per share of $1.45, or an 8.2% increase from $1.34 reported in January 2011. Wal-Mart's (TTM) EPS for January 2012 is an estimated $4.49, and $4.90 for January 2013, a 9.10% year-over-year increase. Furthermore, analysts expect EPS growth of 8.79% over the next five years.
As you look at the first chart below, notice that net income is larger during the first quarter of each year. The stock price does not correlate with net income, but the chart reflects a slight lag in share price increase versus net income. Based on this chart, we could expect net income to spike to between $6 billion and $7 billion in the forthcoming reporting period.
The second chart below shows Wal-Mart's earnings per share in line with net income over the past five years as expected. However, notice that from 2009 the earnings line appears higher than the net income line. This suggests the exaggerated effect that the reduction of outstanding shares has on EPS and also confirms the expectations for the Jan. 31, 2012, earnings estimate.
The third chart represents EPS versus net income over the trailing 12 months, and shows the exaggerated percentage increase in EPS versus net income during the past five years.
Great company -- poor stock
Let's face it. Wal-Mart has become a low-margin, low-growth empire over the past 15 years. While Wal-Mart is arguably a great company, it is a poor stock to own unless you are content with its 2.4% dividend. Savvy investors have recently bid up Wal-Mart's stock price in anticipation of the forthcoming earnings release, but I anticipate the stock price will revert toward its mean over the coming months, as in prior years. Wal-Mart could surprise us with a stock split, as the company has not split its stock in 12 years and historically has split when the price is in the $50 to $60 range. However, the trailing P/E is 13.10 and the forward-looking P/E (estimated) is 12.61, and both are higher than the company's historical or anticipated growth rates.
A better option
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