Grahamites

# Walmart and Coca Cola - How Much is Too Much?

June 16, 2014

A few weeks ago, I wrote an article called “Don’t be Afraid to Pay a Little Bit More.” My conclusion was that truly extraordinary businesses are rare and they rarely look cheap. So when you identify one, don’t be afraid to pay a little bit more than whatever your fair value is.

But then I realized that I didn’t answer the question what a little bit more is. Is paying 1.5 times book value for Berkshire Hathaway a little bit more? Is paying 30 times earnings for MasterCard a little bit more?

After a little while, I came to the conclusion that I’m not smart enough to figure out what exactly is “a little bit more.” Fortunately I don’t have to figure that out as Jacobbi taught us “invert, always invert.” Therefore, I decided to explore what “a little bit more” is not. Obviously anything equal to or less than the range of fair value qualifies but as my concern is not to avoid the folly of overpay, I’m not interested in exploring what’s less or equal to fair value for the purpose of this discussion. This leaves me with “paying too much.”

To answer what “paying too much” looks like, I’ve decided to study two examples of great businesses and derive some implications thereof. Luckily plenty of examples exist. Among all the studies I’ve done, the cases of Walmart and Coca Cola stand out.

Let’s first take a look at the 12 year and 13 year price data adjusted for split and dividends for Walmart and Coca Cola for the selected periods.

Walmart:

 Year Adjusted Ending Price (Data From Yahoo Finance) 1999 55.06 2000 42.51 2001 46.32 2002 40.87 2003 43.21 2004 43.43 2005 38.96 2006 39.01 2007 40.92 2008 49.10 2009 47.83 2010 49.37 2011 56.21

Coca Cola:

 Month/ Year Adjusted Ending Price (Data from Yahoo Finance) June 1998 29.38 June 1999 21.51 June 2000 20.17 June 2001 16.02 June 2002 20.26 June 2003 17.11 June 2004 18.98 June 2005 16.10 June 2006 17.05 June 2007 21.30 June 2008 21.69 June 2009 20.73 June 2010 22.35 June 2011 30.89

I don’t know how many readers will be surprised at the data but I am quite shocked. Keep in mind these prices are adjusted for dividends and split so they reflect total return information. Had you invested in a share of Coca Cola in June 1998, your money is dead for the next 13 years. Similarly, had you put a dollar in the common stocks of Walmart in the beginning of 2000, you would have been barely better off 12 years later.

Both businesses are truly extraordinary businesses with the widest moats on earth. The ROEs for both Walmart and Coca Cola are over 20%. Coca Cola’s earnings were growing at over 15% a year and Walmart’s earnings were growing at 20% a year.

How much were investors paying for those extraordinary businesses then that they suffered for more than 10 years?

It turns out that Investors were paying 51 time earnings for Coca Cola in June 1998 and at the high of 1999, investors were paying almost 70 times earnings for Walmart.

Let me use the total return formula to explain what happened.

Total Return = Dividend Yield + % Change in EPS + % Change in P/E + (% Change in P/E * % Change in EPS)

Had the P/E for Walmart and Coca Cola not changed during the 12 year and 13 year period, total returns, assuming a 2% dividend yield and 15% EPS growth rate, for each company would be:

Walmart : 2% * 12 years + (1.15^12-1) + 0 + 0 = 459%

Coca Cola” 2%*13 years + (1.15^13-1) + 0 + 0 = 541%

We know the total return over the 12 and 13 periods are almost 0% in both cases. Reverse engineer the formula, we can derive the change in P/E ratio during these periods for WMT and KO:

WMT:

 Total Return= Dividend %Change in EPS %Change in P/E %Change in EPS * %Change in P/E 0%= 2%*12 yrs 1.15^12-1 = 435% ? 435% * ?

Solving for question mark, we get a change in P/E equal to roughly negative 85%. This means Walmart’s P/E would have to contract 85% during the 12 year period for investors to not make any money even though EPS would have quadrupled. Remember investors were paying 70 times earnings for WMT in 1999, a 85% contraction implied a P/E of 11, which is not too far from what WMT’s average P/E in 2011.

Applying the same to Coca Cola, we’ll get an even sharper drop of P/E of about 87-88%.

You may argue that this is not what happened in reality. This is because both Coca Cola and Walmart’s earnings growth had been merely 10-12% during the 12 and 13 year period instead of 15%. And when actual earnings growth is slower than the projected earnings growth, a less severe contraction of multiple is needed get to lackluster returns had you paid a very high multiple for a high quality stock.

Now we could tell, with the benefit of hindsight, that paying 50-70 times earnings for the greatest businesses on earth can be categorized as paying too much. How much should we pay for great businesses then? A reader suggested to use Graham’s formula to decide the multiples we would want to pay for a business, namely 8.5 + 2 * growth rates. My personal experiences and observation show that there is some merit to this formula but I would use it more conservatively by tweaking it a little bit.

First of all, I would eliminate all companies whose growth is impossible to predict.Secondly, I would look for companies whose earnings predictability is relatively high. And lastly, I want a business that has a ROE of 15% or more. Through a lot of backtesting, I’ve found the following different versions of Graham’s formula helpful as general rule of thumbs.

1. If growth rate is between 0-5%: 8.5+ 2*Growth Rate

2. If growth rate is between 5-10%: 5+ 2* Growth Rate

3. If growth rate is more than 10%: 2* Growth Rate with a maximum of 50

Let me remind the readers that the assumption here is a great business with high ROE and moderate to high predictability. My experiences and knowledge are very limited and this article is only the result of my study and observation.Therefore, I encourage the readers to do a few case studies on their own.

 Currently 4.90/512345 Rating: 4.9/5 (10 votes) Voters:

Dr. Paul Price - 2 years ago

Earnings yield, the inverse of P/E, is useful indetermining what multiple is 'too much to pay'.

A 50 P/E means buyers are accepting as 2% current year's after-tax return in the hope than future growth will justify the asking price. A 70 multiple is like getting 1.43% after tax. Why risk money for that?

It is never a good idea to take even 2%. 50% growth would only mean 3% one year later and 4.5% 24-months into the future.

No company can sustain 50% over the long term.

Avoiding bad entry points due to valuation is easy. Just pass up high P/E stocks and look for shares offering better current returns. You don't need to swing at every pitch. There is no penalty for waiting.

Grahamites - 2 years ago

Dr.Paul Price - I think Earnings Yield is a good start but it has one fatal shortcoming - it doesn't take into account growth rate and dividend yield. To use the example of MasterCard, throughout its history as a public company, its earnings yield bobs around 2.5%-4%,implying P/E of 25-40, does that mean MA is a bad buy at 3.3% EY?

Also some MLPs are trading at very low EY but the yield is high, given distributable cash flows are not in danger I doubt a low EY is a reason that scares away investors.

But I wholeheartedly agree that with your conclusion -Avoiding bad entry points due to valuation is easy. Just pass up high P/E stocks and look for shares offering better current returns. You don't need to swing at every pitch. There is no penalty for waiting.

Thanks for commenting.

Jtdaniel - 2 years ago

Hi Grahamites,

I would agree with Paul that the earnings yield is an invaluable initial screen. It is a great way to eliminate the great business/ lousy stock trap. For Wal-Mart, the earnings yield of 6 (\$4.88/\$75.43) implies a 6% first year return. I would then look at the historical growth rate of pre-tax income and make any necessary adjustments to estimate a forward rate of return. The 6% first year return would then be compounded by the annual pre-tax growth rate. Using pre-tax income instead of EPS takes share repurchases out of the growth calculation - buy backs just increase the margin of safety. The impact of share buy backs is apparent when comparing the ten year growth rate in Wal-Mart's pre-tax income (4.35%) to that of its EPS (7.31%). Adding the 2.55% dividend yield to the 4.35% pre-tax growth rate indicates a forward rate of return in the vicinity of 6.90%. Using these numbers with such a stable business, I would project a first year return of 6%, to be compounded at no more than 6.90% for a reasonable number of years. A higher rate of return is then dependent on getting a higher first year return, which means waiting for a lower per-share price. Thinking through this exercise helps me focus on the power of long-term compounding and not on short-term volatility. In fact, once a purchase is made at an acceptable projected rate of return, the opportunity to average down should be welcomed, not dreaded.

Grahamites - 2 years ago

Jtdaniel - I agree with Paul that EY is a good initial screen as well. I also think your forward rate return exercise for Walmart is very reasonable. Like you said, it forces you to think in terms of compounding power instead of short term volatility. One thing I would add to the forward rate of return calculation is that it doens't fully include the effect of multiple contraction/expansion.Although a high P/E would be reflected in a low EY, a medium to high EY itself is seldom a good reason to buy unless you are convinced the multiple is low compared to what it should be. In Walmart's case, I don't know how much impact will Amazon have on its business model. If the same day short time period delievery concept (say 1 hour or less) becomes economically viable and Amazon expands its offfering into Walmart's territory, I'd argue both the forward rate of return and multiples will either be stagnant or contract.

Jtdaniel - 2 years ago

Hi Grahamites,

Great points. Here is a separate computation that would better reflect your concerns. As I think Amazon will somewhat impair, but not kill Wal-Mart, a projected EPS growth rate of 6% (down from the historical 7.31%) seems rational. A 6% growth rate for ten years would result in EPS of \$8.74 in 2024. I could then assume a pessimistic multiple of 12 to forecast a 2024 share price of \$104.88. Under this scenario, shares purchased at the June 16 price of \$75.43 would deliver 3.35% annual rate of return, exclusive of dividends.

Grahamites - 2 years ago

Jtdaniel, great great computation:)