FOOL ON THE HILL: An Investment Opinion
Practical Thinking on Wal-Mart

Could an investor in 1980 have predicted that Wal-Mart would be worth $260 billion today? Tom Gardner asked this valid question months ago, and the time has finally come to properly examine it. Using a broad, five-step valuation methodology, it is possible to explain Wal-Mart's business growth over the past 20 years. However, the ultimate answer to Tom's question lies within the valuation process itself.

By Brian Graney (TMF Panic)
August 22, 2000

A couple of months ago -- on June 2 to be precise -- a challenge was issued by the Fool's Tom Gardner in the Rule Maker portfolio. In the context of an article concerning the proper role of valuation in long-term investing, Tom said the following:

"I hereby encourage the valuation superstar out there who can use all the available data (there's tons of it) to show me the valuation methodology that:

  • in 1980, proves Wal-Mart (NYSE: WMT) will be worth $260 billion today
  • in 1990, proves Microsoft (Nasdaq: MSFT) will be worth $350 billion today
  • in 1994, proves Cisco (Nasdaq: CSCO) will be worth $450 billion today"
I'm no valuation superstar, to be sure, but the challenge nonetheless struck me as interesting. Given what we know in 2000, could we time warp back a number of years and explain present day using only historical data and hindsight? This is, in effect, much the inverse of what a long-term equity investor typically does, which is to use present day data to extrapolate the future. Surely, I reasoned, this could be done somehow.

Taking the plunge
After a few months of foot-dragging and head-scratching on my part, I've decided to take Tom up on his challenge, or at least a third of it. Using only publicly available information and the glorious advantage of hindsight, I'll try to explain how it could be seen, using today's information, that Wal-Mart in 1980 would achieve a market valuation of $260 billion by 2000. I'll leave the proofs for Microsoft and Cisco to others.

Instead of comparable P/Es, discounted cash flows, or some other model, I'll rely on a valuation methodology from Berkshire Hathaway (NYSE: BRK.A) vice chairman Charlie Munger, who, coincidentally enough, was quoted by Tom at the beginning of his June article. In a 1996 speech, Munger did a similar "back in time" valuation for soft drink giant Coca-Cola, pretending to go back to 1884 to explain (in very broad terms) how that company could achieve a market valuation of $2 trillion by 2034. Thankfully in the case of Wal-Mart, I'll only need to go back a fraction of that time span and explain little more than an eighth of that final valuation.

Munger employed five of what he called "ultrasimple general notions" in his hypothetical Coke example. I'll use the same five, which are:
  1. Solve the big no-brainer questions first.
  2. Use math to support your reasoning.
  3. Think through a problem backward, not just forward.
  4. Use a multidisciplinary approach.
  5. Properly consider results from a combination of factors, or lollapalooza effects.
No-brainer questions and lollapalooza effects
From the SEC's Edgar database and Wal-Mart's website, I discovered that Wal-Mart in 1980 operated 276 stores in the U.S., had about $1.2 billion in annual sales, and sported a market capitalization of just over $1 billion. As of early 2000, the storecount had grown to a total of 4,056 units in different formats worldwide, annual sales had expanded to over $165 billion, and the firm's market valuation had ballooned to $260 billion, as previously mentioned. How could someone in 1980, armed with this knowledge from 2000, have seen this value creation monster coming?

Pretending to be Wal-Mart in 1980, you first need to make several no-brainer decisions early on. To expand your market value 260 times in just 20 years, you'll need to target a big market. In the U.S. alone, retailing is a $3 trillion-a-year business, representing nearly a third of national gross domestic product (GDP). That's a pretty fat market.

The next no-brainer question to be answered is what to sell. To be the country's largest retailer and get the most of the business pie, you can't be limited to just a certain niche. Also, you should logically sell products with broad appeal, such as clothing, food, and sundry other items that many people would find useful for everyday life. Wanting lollapalooza effects, you'll sell all of these things.

A varied merchandise mix will also give your stores universal appeal, allowing them to work well in small and large communities both domestically and also around the world. This means even more lollapalooza effects for you, as your stores can thrive in many different environments and populations. Your universal appeal will also allow you the ability to expand rapidly and sustain a respectable growth rate.

But to get people into the stores, you must address one more no-brainer question. This is the age-old question of consumers everywhere: how to get the most value at the least price? The answer, in retailing lingo, is to lower the markup and increase the volume. So, you must adopt an "everyday low price" strategy and use low prices as your main marketing tool.

Then again, to keep people coming back to you and prevent them from going to other low price imitators, you'll need to offer more than just low prices. You'll need a focus on customer satisfaction and total staff excellence. For a lollapalooza result, you'll offer both of these things. Further, you'll need customer satisfaction and total staff excellence in every one of your stores. Thus, you must establish and maintain a culture devoted to service and excellence and make sure it is exhibited by all of your employees.

Using math and psychology
With the big no-brainer decisions out of the way, it's now time to use some math. To get to $165 billion in total sales by 2000, you'll need an enormous amount of foot traffic. As Motley Fool Research analyst John Del Vecchio relates in his research report on Wal-Mart, some 100 million customers shop Wal-Mart each week. That equates to 5.2 billion individual customer visits per year -- enormous by just about any standard.

To generate such an enormous amount of traffic, you'll need to look to the discipline of psychology and rely on the general principle known as "the social proof." Knowing that shoppers can be influenced to spend based simply on their "monkey see, monkey do" tendencies, you can use social proof to trigger what Munger has called "imitative consumption."

Thankfully, by 2000 you'll employ a lot of initial "monkeys" -- 885,000 of them in the U.S. alone. A force of 885,000 domestic employees represents quite a societal force for influencing action, being roughly equal in size to the populations of Montana or Vermont. Presumably, these employees will spend some of their discretionary income at your stores, providing a portion of your needed foot traffic. Better yet, they will also presumably be able to sway the consumption decisions of friends, neighbors, and family members, helping to catalyze social proof effects.

"Invert, always invert"
Now, with the social proof helping to generate your enormous foot traffic, it's time to return to the numbers. Working in reverse, you'll need to generate an average ticket of just $30 from each of the 5.2 million annual customer visits to get to $156 billion in annual retailing revenues. Given your varied merchandise mix and the higher levels of disposable income of consumers in 2000 compared to 1980, this seems attainable. Of course, many visits will yield no sales at all, while many others will yield total sales two or three times the average ticket. But on average, a $30 average ticket per customer visit does not seem particularly outrageous.

With an additional $9 billion in revenues coming in from a healthy wholesaling business -- which is operated on the same principles of value, service, and excellence as the retailing business -- you can achieve the requisite $165 billion in 2000 sales. So, you're at the year 2000 finish line, except for one small item: How much is all this worth?

Like the average ticket estimation, this requires a judgment call as well. Consider that every dollar of Wal-Mart's sales in 1980 was only being valued by the market at $0.83. With all of the improvements to Wal-Mart's business over the past 20 years -- its domestic and international expansion, it's consistently strong growth rates, the lollapalooza effects from additional merchandise categories, the competitive advantages it has received from the social proof -- isn't it reasonable to expect that every revenue dollar today should be valued higher than in 1980? At just twice the 1980 multiple, or $1.66 of market value for every revenue dollar, we can see Wal-Mart at a $274 billion valuation in 2000, a bit ahead of our target.

Concluding thoughts
It's likely, though, that Tom may find fault with this proof and the valuation methodology employed. In fact, I'd probably agree with him on many points. After all, to envision today's Wal-Mart in 1980 would have entailed some pretty aggressive assumptions and high expectations. It would give new meaning to Sam Walton's own statement, "High expectations are the key to everything." But that does not mean that the exercise of valuation, using a framework like the one suggested by Munger, is useless or an utter waste of any investor's time.

There are weaknesses in every analytical model, just as there are shortcomings in every human individual. The trick with valuation is to understand what it is and what it is not. It is not about finding the right black box that will spit out the right magic number at the end of the day. Rather, it is an exercise into understanding the fundamental elements of a business and thinking critically about what the future may hold. In the end, it is the valuation journey itself that yields the most insights for an investor, not the final destination.

Related Links:
  • Motley Fool Research Products -- Wal-Mart
  • The Case for Quality -- Rule Maker Portfolio