I recently looked at a simple way to separate the wheat from the chaff in the stock market. I focused on four areas -- earnings growth, valuation, dividends, and share growth -- and yielded an idea of what kind of returns you can expect from a given stock.
Using that framework, let's see if we can expect big returns from a big stock -- namely, Wal-Mart
As I outlined in a previous article, a good way to get a baseline for growth expectations is to check on what Wall Street analysts expect and how fast the company has actually grown in the past.
|Annual Growth Rate|
|Last 12 months||10.3%|
Source: Capital IQ, a Standard & Poor's company. Growth based on diluted earnings per share excluding discontinued operations and non-operating adjustments.
Now comes the tough part: How fast do we actually believe Wal-Mart can grow? As has been well covered in the news, Wal-Mart's U.S. locations have been struggling as sales have basically flat-lined. But does this mean that Wal-Mart's bottom line is doomed to go nowhere?
Even as the Wal-Mart stores in the U.S. have struggled, Sam's Club has continued to grow, and the company's international operations have done very well. Additionally, the company has been actively buying back shares, which gooses earnings per share. So if I assume that U.S. stores continue to stay flat, but that Sam's and international continue to grow, margins stay roughly the same for each segment, and the company continues to buy back shares at a similar rate, I can easily get to a 5% annual growth rate for the next five years. Now that's not nearly what analysts are expecting, but I'm working with some relatively conservative assumptions.
So for our growth range, I'll give the analysts a nod by setting the top end at 10%, use the 5% I calculated as the baseline, and cut that down to 2% for a downside scenario.
Pinning down valuation
Valuations are a moving target that can be tough to predict, but, as with the growth above, using a range of values can give us a view of our potential returns without requiring a Miss Cleo-type prescience.
In creating our range, a good place to start is where the stock is trading right now and what its historical trading range has been. In Wal-Mart's case, the stock has a current price-to-earnings ratio of roughly 12.5 times its trailing earnings (after adjusting for discontinued operations). Over the past decade, it's had a very wide trading range with an average annual P/E as high as 42 in 2000 and as low as 13.4 over the past 12 months.
For broader context, we can also look at how similar companies trade.
||Home improvement retailer||18.4||14.5%|
||Pharmacy / retailer||13.3||11.3%|
Source: Capital IQ, a Standard & Poor's company.
Obviously these businesses aren't all exactly the same as Wal-Mart. Target is close, but it doesn't have the growing warehouse club that Wal-Mart does. And while Costco is a warehouse club, it isn't burdened with the large, currently not-growing standard retail segment. Meanwhile, the other companies mentioned have a focus more narrow than Wal-Mart's.
This comparable group is only moderately helpful, though. Wal-Mart's 12.5 multiple falls in at the low end of this mix, but the wide range suggests that investor sentiment is very different across these stocks.
So what do we do with Wal-Mart? On the optimistic end, I could see investor views on Wal-Mart turning as the overall market continues to charge ahead and the stock grabbing a multiple as high as 20. In my baseline case, I figure investors will pay a multiple more in line with the market's average -- I assumed 15. And on the downside, I could see the multiple falling a bit further to 12.
Since we already considered share count above, that leaves us with dividends.
Even after the company's recent 21% dividend increase -- which will put the stock's yield near 3% -- Wal-Mart is still not a stock that high-yield-chasers are going to be yearning for. However, the company has been a very reliable dividend payer and grower over the past decade, raising its payout every year over that period for a total increase of more than 400% (and that doesn't include the most recent increase).
Considering the company's strong historical rate of dividend growth and its low payout ratio and weighing that against potentially slower earnings growth, I think there's the potential for dividend growth as high as 15% annually, but it'll more likely be around 10%. At the low end, I think the company will still grow the dividend by at least 7% per year.
The verdict, please!
The end result of all of this is the returns we can expect under the various scenarios. Here's what my three scenarios would look like.
Annual EPS Growth
Annual Dividend Growth
Expected Annual Returns
Source: Author's calculations.
Let's now go back to that question that we started with: Can Wal-Mart's stock double? Under the upside scenario, the answer is a very definite "yes." The more likely mid-case scenario wouldn't offer a double over the next five years, but those expected returns are still pretty attractive for a company as large and stable as Wal-Mart. That's why I own the stock personally and why it's a favorite of mine among the consumer staples.
Of course, the future is an ever-changing picture, so you need to keep on top of what's going on at Wal-Mart to see which set of numbers the company and stock are able to live up to. And you can do just that by adding Wal-Mart to your Foolish watchlist.
Costco, Home Depot, and Wal-Mart are Motley Fool Inside Value selections. Costco is a Motley Fool Stock Advisor recommendation. Wal-Mart is a Motley Fool Global Gains pick. Motley Fool Options has recommended a diagonal call position on Wal-Mart. The Fool owns shares of Costco and Wal-Mart. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
Fool contributor Matt Koppenheffer owns shares of Wal-Mart, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.