Tannor Pilatzke

# Save Money, Live Better: The Intrinsic Value of Wal-Mart

“Any business is worth the sum of free cash flow it will generate from now to eternity, discounted to present value using a reasonable risk-free interest rate.”Warren Buffett (Trades, Portfolio)

There are a number of assumptions, estimations, biases and ways to value a business, aka, find intrinsic value (sum of the parts, salvage value, discounted cash flows, Gordon dividend model, etc.).

I figured I would do a quick run down of Wal-Mart to illustrate how to calculate intrinsic value using a discounted cash flow approach. I would encourage the reader to conduct a similar exercise with his or her personal investments and calculate the expected future cash flow of their holdings.

It would also be very interesting to see other readers intrinsic value calculations to illustrate Warren Buffett (Trades, Portfolio)’s point: “Two people looking at the same set of facts, will almost inevitably come up with at least slightly different intrinsic value figures.”

Calculating on a 10-year basis is suggested so that it can be compared to a 10-year note, and extrapolation errors do not create a large variance. It is also suggested to break the growth rate into two sections years— one to five and years six to 10 — with an option to either use a terminal value of cash flows or an assumption the business is sold in the 10th year.

Step One

The first step in calculating intrinsic value is determining what the initial cash flow is. There are a number of ways to go about calculating the initial cash flow. From cash flow from operations (CFFO) and operating income to free cash flow (FCF), net income and cash flow from continuing operations, there is not a cash flow that is better than another and all should be viewed under various lights, subject to slight adjustments.

Adjustments that should be made are for one-time gains or losses, depreciation, tax, interest (leverage) and cyclical growth. In the example below I chose to use the average of the 2013 CFFO of \$25 billion (ex-cash flow from others) and the 2005 CFFO of \$14.6 billion. The initial cash flow in this case would be \$19.8 billion. There are multiple ways to arrive at an initial cash flow, and a 10-year average is also a common approach.

Step Two

The second step is the one I consider most difficult, and the one that is subject to the most speculation due to the non-linear nature of future earnings growth and the uncertainty of the future. It is best to use conservative estimates particularly if using terminal value cash flows in your analysis. A general heuristic is to use the last five to 10 years' average growth rate as the first five years of your calculations. In the case of Wal-Mart’s CFFO, it has grown on average by roughly 7% since 2005.

The next input will be the growth rate in years six to 10, and it will be lower than years one to five barring certain situations (large capex projects coming online and providing additional capacity to a market with sufficient demand) and generally we take 70% of the first one to five years unless justification can be made for expanding margins, pricing power, or another component of widening the moat.

Remember trees do not grow to the sky. To illustrate this point, take cash flow from operations of \$20 billion and capitalize it at 20% for 10 years. We end up with \$123 billion; no company in the world has this kind of CFFO.

Finally, a terminal value growth rate must be chosen or a multiple to assign to the 10th year cash flow. If terminal growth is chosen, a 10-year average of the global GDP growth rate should be used (provided the company is a multi national enterprise). If a multiple is chosen, one could justify using an industry average or 6x to 8x multiple on the 10-year cash flow.

 Wal-Mart (NYSE:WMT) Initial Cash Flow: \$19,800 Years: 1-5 6-10 Growth Rate: 7% 5% Terminal Growth Rate: 3% Discount Rate: 10% Shares Outstanding: 3,389 Margin of Safety: 50% Debt Level: \$38,400

Step Three

Step three is selecting a margin of safety and discount rate. Ben Graham advised never purchasing a security if it did not yield a 30% margin of safety; Warren Buffett (Trades, Portfolio) had a margin of safety of 50% and his crosshairs zoomed in on a hurdle rate of 15% at all times.

Using a discount rate of 7% to 13% is common depending on the environment, with 10% being the most common. Personally, I think of a discount rate as an opportunity cost, or what return I could receive elsewhere and elect to keep it simple, almost always using a 10% discount rate or higher. Another general rule of thumb is the larger the margin of safety the higher annualized return one can expect. If you are like Warren Buffett (Trades, Portfolio) or most value investors you will demand a 50% or higher margin of safety and/or a 15% or higher annualized return.

Shares outstanding and the current debt level are quite simple to retrieve and calculate. Shares outstanding can simply be found in the most recent SEC filing. Share dilution through stock options should also be accounted for; in this case for simplicity we will assume none. One should use long-term debt and subtract the amount from the present value of cash flows (once they are calculated).

 Year Flows Growth Value 1 21,186 7% \$19,260 2 22,669 7% \$18,735 3 24,256 7% \$18,224 4 25,954 7% \$17,727 5 27,771 7% \$17,243 6 29,159 5% \$16,460 7 30,617 5% \$15,711 8 32,148 5% \$14,997 9 33,755 5% \$14,316 10 35,443 5% \$13,665

Step Four

Bringing it all together we take the sum of the present value of cash flows from years one to 10 and subtract outstanding debt. We then divide by the total number of shares outstanding. (Note: We did not incorporate an annual dilution rate into the shares outstanding count.)

\$166,337 – 38400 = \$127,937 / 3389 = 37.75 per share

We then take the 10th year cash flow (\$35,443) and multiply by the terminal growth rate (1.03) to find a terminal year value of \$36,506. Finally we use the discount rate minus the terminal growth rate (0.10 – 0.03 = 0.07) divided by 1.10^-10 (discount rate to the power of time period) which is about 5.5 and multiply by the terminal year value.

 Terminal Year \$36,506 PV of Year 1-10 Cash Flows: \$166,337 Terminal Value: \$201,068 Total PV of Cash Flows: \$367,405 Number of Shares: 3,389

We follow the procedure from above and divide the gross terminal value by outstanding shares and find 201,068 / 3389 = \$59.33 per share. If we combine both per share figures we arrive at an intrinsic value per share of \$97.08.

 Intrinsic Value (IV): \$97.08 Margin of Safety IV: \$48.54 What Percentage of IV comes from 55% the Terminal Value:

As one will be able to examine immediately, a large portion of intrinsic value (over half) is derived from the terminal value cash flows or multiples assigned to the sale of the business. Instead of using terminal value of 201,068 we used the 10th year cash flow of 35,443 and assigned a 6x CFFO multiple to Wal-Mart we would arrive at a terminal or sale value of \$212,658, leading to an addition of \$3.42 per share of intrinsic value. There is roughly a 23% margin of safety currently for Wal-Mart, I would need to purchase below \$50 to have my hurdle rate satisfied.

Using the most recent closing price of \$74.50 we can see that Wal-Mart is selling for less than intrinsic value but under the following assumptions what would the expected annual return be for the next 10 years? Unfortunately it would only be 2.7% annually (excluding dividends) — timing unfortunately does matter. If we include a very generous estimate of 3.3% for annual dividend distribution, we arrive at an expected return of 6%, a modest but acceptable return.

“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety...” – Warren Buffett (Trades, Portfolio)

If we were to quickly change the growth of years one to five to 10%, years six to 10 to 7% and assigned a 10x multiple on year 10 cash flow we end up with \$188 per share of intrinsic value.

It goes to show how subjective a DCF analysis can be, and understanding the components that effect future cash flow growth is the all-important question one must answer.

“The stock market is a no-called-strike game. You don’t have to swing at everything –you can wait for your pitch. The problem when you are a money manager is that your fans keep yelling, ‘Swing, you bum!'" – Warren Buffett (Trades, Portfolio)

Tannor Pilatzke
I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website

 Currently 4.15/512345 Rating: 4.2/5 (13 votes) Voters:

Grahamites - 3 years ago

Agree with your general calculation method but think you should add a dividend factor to the intrinsic value too b/c dividend is not incorporated in your FCF.

Gerrydjr - 3 years ago    Report SPAM
Excellent article.
Rollling - 3 years ago    Report SPAM

There's something I don't understand. If:

1- you calculate the intrinsic value as being higher than the current market price

2- you used a 10% discount rate

AND IF

then how is it possible that

4- your expected return is below 10%?

Isn't the discount rate the required rate of return?

ps: my questions don't intend to be critical, I'm not from the financial area and I might have understood it all wrong...

Tannor - 3 years ago    Report SPAM

Thanks Gerry and Grahamites,

I completely agree dividends should be factored and the share dilution or reduction rate should also be included i nthe analysis. I used an arbitrary 3% cagr as the dividend discounted. If we estimated the initial dividend distributions to be \$5300 and used 14% growth - years 1-5 and 10% growth - years 6-10 (2% there after) and include a 3% buyback rate (27,657 shares outstanding 10th year) we arrive at an intrinsic value of 148.44.

This would lead to an annual return of 7.14% versus the 6% calculated.

This is by no means the definitive intrinsic value although I believe it to be a close enough picture. Margins could expand from 5-6% to 7-8% and increase intrinsic value by 20-30% as well.

“Two people looking at the same set of facts, will almost inevitably come up with at least slightly different intrinsic value figures.”

Cheers,

Tannor - 3 years ago    Report SPAM

Skyaboveyou, no problem.

The discount rate takes into consideration the time value of money and is not the expected return itself but a subjective "break even" point. Yes excess return and total return are different and suppose I should have made that clearer after the 6%. The higher the rate used the more uncertain the future cash flows, the lower the rate the more clarrity there is.

Ask yourself a simple question, would you be willing to lend me \$1000 today and I will pay you back \$1000 ten years from now?

I would assume the answer is no, because you have a more productive place to put the \$1000.

Framing the question differently what amount would you lend me today for \$1000 in 10 years?
It depends on your alternatives, I chose 10% using a 10-year treasury average + a risk premium, it is the most common discount rate in the field. Some companies when financing projects use the WACC (weighted average cost of capital) as the discount rate or hurdle rate.

This of course if the subjectivity that I am referring to throughout the article, by lowering the discount rate to 7% the intrinsic value roughly doubles. I hope that helps explain, essentially \$1 today is not worth \$1 ten years from now due to opportunity cost and inflation.

Cheers,

Rollling - 3 years ago    Report SPAM

But unfortunately I continued with the same doubt because first you say:

"The discount rate takes into consideration the time value of money and is not the expected return itself"

but then

"Framing the question differently what amount would you lend me today for \$1000 in 10 years? It depends on your alternatives, I chose 10% using a 10-year treasury average + a risk premium"

which means that you'd lend me 386 dollars for 1000 dollars in 10 years (a coumpounded 10% rate of return), which you would receive if you were right that I would pay it by then

So isn't it the same when you use a 10% discount rate in a stock? don't you expect (if you are right on the valuation as you were right that I would pay you back) to earn the same 10% coumpounded? And in this case the margin of safety would be needed in case you were wrong and because you actually wanted more than 10% (meaning that you'd only lend me 193 dollars for my promise of 1000 dollars)

ps: this discussion is important to me, unfortunately I might not be able to answer soon so I thank you in advance for your attention (and for all your articles and blog - which is on my favourites on Chrome for some time)

Tannor - 3 years ago    Report SPAM

Yes exactly correct.

I am sorry for this misundertanding between total returns and excess returns. My fault for lack of clarity.

In the article the 6% described would be in addition to the rate used to discount the cash flow or 16% total return. The expected return or excess return being the 6% - the 10% being the discount rate used.

Cheers,

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