The question we would like to ask now is: are these stocks still cheap?
To see if these stocks are cheap, we would like to check their valuations with three evaluation methods: DCF Calculation, Reverse DCF Calculation, and Peter Lynch Chart. Since all these three companies have quite stable and predictable business, DCF and Reverse DCF will work pretty well.
Wal-Mart has been growing its revenue by about 3.5% a year over the past 5 years. Its earnings grew faster, at about 5% a year, due to margin expansions. Coupled with about 4% a year of share buybacks, this giant company has been growing its earnings per share at the rate of 10% a year. Considering Wal-Mart has a very stable business, we may ask for lower discount rate in DCF and Reverse DCF Calculation. At 10% of discount rate, Wal-Mart is worth about $88 a share, which gives a margin of safety of 15% at the current market price. Please see the screenshot of the DCF Calculator below:
If we switch the DCF Calculator to Reverse DCF mode, it gives a growth rate of 7.8% as shown below:
Over the past 10-year and 5-year periods, Wal-Mart has grown its revenue and earnings per share slightly faster than that. Based on the calculation, we can confidently see that Wal-Mart is probably slightly undervalued or fair valued.
This is further confirmed by the Peter Lynch Chart of Wal-Mart below:
Historically Wal-Mart was traded at much higher valuations. Please see the historical P/E chart below:
Currently Wal-Mart is traded at the P/E ration of 15.1. The lowest point was below 12 at about two years ago.
Microsoft has been perceived as a company that has had its days. Indeed, its growth rate has slowed down dramatically over the past 5 years. But the company has very strong cash flow, which allows it to buy back shares while still growing its sales. The 5-year average earnings per share growth rate is about 6.6%, which is the rate we use for DCF Calculation. Because Microsoft carries tremendous amount of excess cash, we added its tangible book value to its DCF calculation. The DCF screen shot is below:
The DCF Calculation gives a fair value of $32, which is 7% below its current price. The Reverse DCF suggests that the company needs to grow its eps at 7.8% a year, which is slightly higher than its growth rate over the past 5 years. This may suggest that Microsoft is slightly overvalued.
This is the Peter Lynch Chart of Microsoft:
The Price Line and the Earnings Line are close to each other, again suggesting fair value for Microsoft.
ADP is the slowest grower among all these three companies. The historical low interest rate hurt its growth and margins. The company grew its revenue at about 5% a year over the past 5-years, while its margin shrank and its profit declined. Even with share buyback, the company only grew its earnings at about 3% a year. Assuming 6% growth, 10% discount rate for DCF Calculation, the stock still appears to be overvalued. This is also confirmed by the Peter Lynch Chart:
Historically ADP has been traded at a higher P/E. The historical median P/E ratio is 23.6, which is exactly where it was traded at. ADP price and its Earnings Line of historical median P/E of 23 is shown below:
Therefore, ADP stock is probably somewhere between fair-valued to overvalued.
With the recent stock market run up, many large cap stocks that were out of favor are not undervalued any more. Among all the three companies discussed here, none of them is clearly undervalued. If one has to invest one of them, Wal-Mart would be the best choice, although most likely it will not deliver as large gains in the coming years as it did in the last two years.
As suggested by GuruFocus market valuation page, the US market is overvalued, and it is positioned by the annual gain of 2-3% a year in the coming years. We do not know where the stock market will go, but as value investors, the bottom up approach clearly indicates that bargains are much harder to come by these days.
We believe that our DCF/Reverse-DCF Calculator and Peter Lynch Chart can help you realize this, too.
In the meantime, please let us know what you think. Please leave your comments below.