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Geoff Gannon
Geoff Gannon

Blind Stock Valuation #2: Wal-Mart (WMT) – 1981

June 04, 2012 | About:

Back on May 16, I posted a blind stock valuation. Thats where I give you financial data without a company name. You then try to value the business purely on the financials.

I told you I also lied about a single, identifying characteristic of the stock.

Based on the title of this article, youve probably already guessed that the company I had you valuing blind was Wal-Mart (NYSE:WMT). And that the single identifying detail I lied about was time. I gave you financials that I said were for the years 2001 through 2011. That was a lie. They were for 1971 through 1981. If you had known that, you wouldve known the stock was Wal-Mart.

In the emails people sent me no one guessed I had lied about the years and no one guessed this was Wal-Mart. So, the email responders really were valuing the stock blind.

By far the most common intrinsic value estimate for the stock was $30 to $35 a share at least two-thirds of the responses I got fell almost exactly into this narrow range.

Which was a big disappointment.

This is a value investing site. So I should expect that kind of valuation approach. But its also a Guru site some place where folks who adore Warren Buffett come and I doubt Warren Buffett wouldve valued Wal-Mart as cheaply as you guys did. He might not have paid $30 or $35 a share for the stock. But in many of the blind stock valuations I was sent neither would you. Many people responded that they would value this unknown stock which we now know is Wal-Mart of the early 1980s at 15 times earnings and would want to buy it around 10 times earnings.

I admire the frugality of those responses. And perhaps if you buy few enough stocks (say, one a year) there is no problem with never being willing to pay a double-digit P/E ratio yourself. But there is something very wrong with believing that a stock whatever you may be willing to pay for it is actually never worth more than 15 times earnings.

Now, of course, nobody said a stock is never worth more than 15 times earnings. People talked about how if this growth rate was sustained mathematically you could argue the stock was worth 30 times earnings.

Sure. But thats the least interesting thing you can say about the stock. There is one point about growth where I think Warren Buffett and Ben Graham are largely in agreement:

Growth is best viewed as a qualitative rather than a quantitative factor.

Ive talked a little about this in the past with Warren Buffett and especially Coca-Cola (KO).

I said what Warren Buffett and Charlie Munger have said many times. That where Coca-Cola had been introduced in countless different countries on several different continents, it had seen increases in per capita consumption. This was not a secret. Coca-Cola has shown decade by decade consumption per capita data for various countries in the past.

In recent years, youve seen this trend top out in some very highly developed countries that have had Coke for a long, long time.

Buffett has also said and even made a point of saying that other people keep ignoring this fact that Coke is a cola. And cola has no taste memory. You can drink a lot of it. Without getting sick of it.

Buffett should know. Before buying stock in Coca-Cola, he had been a long-time drinker of large amounts of Pepsi. Probably something like 6 cans a day. And he didnt get sick of it.

The key to Buffetts investment in Coca-Cola his margin of safety was repeatability. You didnt have to sell people again on Coke. If they drank it yesterday they would drink it today. And if historically it had been true that wherever you introduced Coca-Cola, whether it was the U.S., Mexico, Italy, Malta, or any other country people were drinking more and more of it, then you could count on growth. It was inevitable. Coca-Cola didnt have to break into new countries. It wanted to. And Buffett hoped it would. All it had to do was sell more Coke per capita. And Buffett was sure Coke could do that. And that Cokes margins on those customers were stable. In other words, there would be reliable growth and it would be profitable growth.

Ive actually talked to a few people who dont believe this explanation. There must have been more to Buffetts Coca-Cola investment.

Sure. There were 2 other things:

They sold non-core assets (they re-focused)

They were buying back stock

Anytime youve got:

A repeatable formula for success


And share buybacks

Youre going to get Warrens attention.

The key to Buffetts investment in Coca-Cola was that he knew there would be reliable growth and it would be profitable, reliable growth.

At 9 out of 10 companies this is not true. Most companies cant rely on growth. And those that can rely on growth certainly cant rely on profitable growth.

Ive talked about the TV business before. Everybody knew TV was going to take off after World War 2. In a couple decades it had done so in the most amazing way. And by the 1970s, almost anyone who had been involved in the TV business even those who had been the leaders were looking for someplace to hide. Some niche of growth and profits away from the commodity product.

Now that might sound like a cautionary tale of how growth plays out and how you have to scoot fast when it does. In 1950, TVs are exciting. The industry grows. By 1970, you have to get out of the business. Well, at least it was nice while it lasted.

Except it wasnt nice.

Not for most of the players. Its not like 40 different companies are going to make a lot of money on TV sets even if the market is growing from almost 0% of the population to almost 100% in a couple decades.

Its still going to be the case that only a few players will make any money. Its not unusual in any market for the top 2 or 3 companies alone to share all of the economic profits. Some other guys may make their cost of capital. But I cant think of many businesses with direct competition between the players where more than 3 of them are earning more than their cost of capital and still growing.

Some industries look that way. But they are usually a bit of a mirage. Ive mentioned advertising agencies before. They like other client based businesses can sometimes have very different economics between existing and potential customers. Its one thing to say more than 3 advertising agencies can co-exist with all of them earning their cost of capital and growing at the same pace as their existing clients advertising spending. Thats entirely believable. When you get into winning new business I wonder if the economics are anything like the company wide returns on capital we see.

In any business where you have high retention rates, the economics of keeping current clients may support a lot more than 3 companies in the same industry growing at the same speed as GDP or faster while earning their cost of capital.

But those kinds of markets are pretty rare. And even in those markets, there was often delayed direct competition between some of the players they were able to mature in different places and only came into direct competition later after their period of fastest growth.

What does this have to do with Wal-Mart in 1981?

Seeing 10 years of financial data tells you a lot more than seeing just one year of earnings data. And yet most estimates were no different than if I had shown you just Wal-Marts earnings from last year.

The first thing to do when youre given a growth rate is not geometry. Its biology. How is this happening? How can a company grow 43% a year over 10 years?

Now, yes this was a high inflation environment. But we are still talking about at least a 30% compound rate of real sales growth over 10 years. Thats unbelievable.

You would think it was some hit product or something maybe technological. But its obvious from the mystery stocks margins that isnt true. It cant be something like that.

Lets look at Wal-Marts gross margins from 1971-1981 and Apples gross margins over the last 10 years:

Wal-Mart (Then) Apple (Now)
Year 1 26% 28%
Year 2 25% 28%
Year 3 25% 27%
Year 4 26% 29%
Year 5 25% 34%
Year 6 26% 34%
Year 7 26% 40%
Year 8 26% 39%
Year 9 26% 41%
Year 10 26% 47%

Wal-Mart did the same thing year after year. Apple did something different. Its not just a matter of the technology involved. Its a matter of the competitive environment.

Wal-Mart earned very good returns on capital growing very quickly in the 1970s. It did it without changes in the gross margin. The demand situation for the companys business really didnt change. The company controlled its own destiny and moved out from one local market to the next dominating the competition. It was just a superior predator hopping from island to island and upsetting the locals causing extinctions.

Apple is a phenomenon. You dont even need to know anything about either business and certainly you dont need to see their names to see how different these two operations are. Not just today. But even when Wal-Mart was in its fastest growth phase it was qualitatively a totally different kind of growth than Apple has experienced over the past 10 years.

Is boiling growth down from 10-year data that shows the richness of a whole business system into just a single compound rate really a good idea.

Thats why I say its more about growth in biological terms rather than geometric terms.

If I had shown you a blind stock valuation of Apple and you came back with the kind of response many people gave for Wal-Mart, that wouldve made more sense to me. Because the business that emerges at the end of Apples last 10 year run has zero resemblance to the business that began that 10-year run.

But the blind stock valuation of Wal-Mart actually shows how remarkably similar the business is over 10 years. Its just repeating this pattern of insanely fast growth. But that isnt fundamentally changing the business. Many of the ratios you would expect to be thrown completely out of whack in a period of fast growth actually stay pretty stable through Wal-Marts run. Its like the company is doing the same thing over and over and over.

You can see that in the blind stock valuation. You dont need the companys name. The numbers tell you that. The stability over 10 years with every number growing like bacteria tells you this is a business based on some sort of reliable replication.

Now, sure, something might come in and disrupt the business. Every business faces that risk.

There used to be cougars across all of what is today the United States. At that time, their biggest competitor was probably the wolf. Well, suddenly some folks from Europe came over reproduced like rabbits and spread out across the continent killing those cougars off pretty bad and their biggest enemy the wolf off even worse.

That happens. And Im not asking anyone to have the amazing predictive powers required to short Cougars while The Mayflower is still in transit. You wouldnt know what questions to ask. Youd say Will there be more wolves or fewer wolves in 400 years?

And Id say: Hardly any. A couple tiny dots on the map. Isolated. Nothing to worry about.

And youd think it looked pretty good for cougars. Because you couldnt see any other threats on the horizon and I just told you a big competitor would be almost entirely eliminated.

That stuff is too hard to guess. You cant be expected to predict European colonization before it happens. Big changes like that are outside our view. And were always going to be blindsided by them.

Likewise, some complications are hard to figure out. A lot of times something changes in ways that both helps and hurts one of the players in a bunch of different ways all at once that will trigger chains of events that are just about impossible to understand until you can watch them play out for a while.

In the cougar, wolf, human example in North America deer are the ones that would be really hard to figure out.

Its way too hard to guess if deer are going to be a bigger or smaller population in the U.S. as the human population exploded because while people eat deer they fear the things that eat deer.

So, yes, we know cougars and wolves will be completely removed from some places. But do we know if people will hunt deer there to extinction. Or will they leave some be. And if they do, wont those deer have a lot less to worry about.

You can try to figure these things out. But its usually too hard. When youve got that much change analysis is going to be impotent. The place where analysis is most powerful is where you have a lack of change where both the historical record and your understanding of the reasons for that record support a clear view of the future looking a lot like the past.

No one can guess the fall out from a lot of change ahead of time. No one is saying you have to foresee what Amazon (NASDAQ:AMZN) would become to understand Wal-Mart. All you have to do is recognize changes after theyve happened. Not predict them ahead of time.

No one is even saying you had to foresee what Sam Walton would build. I only asked for a blind stock valuation of Wal-Mart after it had been a public company for a full decade. After it had $1.6 billion in sales. It was hardly a start up at that point.

The important thing is not to fixate on a couple numbers in isolation. I dont really want you to do future projections using the past growth rate. Nothing is going to grow in the future as it did in the past.

But something that grew over 30% a year over the last 10 years while earning a decent return on assets and having a gross margin that barely budged in any year, is something strange. It is nothing like Apple. It is clearly something that is repeating the same maneuver over and over again.

Yes, you need to see what that maneuver is. Maybe if its a for profit education stock maybe you think its not a sustainable maneuver. Thats fine. And I wouldnt fault anyone for saying you need to really investigate the durability of this companys competitive advantage.

But theres no doubt this company had a competitive advantage. And theres no doubt it endured for 10 years. You cant post the kind of results Wal-Mart did through the 1970s while switching strategies. You have to have one thing going for you. And it had to be the same thing for the whole decade.

Now, some people did a wonderful job with this blind stock valuation. I got several emails from folks who immediately recognized this had to be a retailer. The gross margins were obviously a huge tip-off. They were low. And they were unbelievably steady. And yet the company was growing super fast. Its hard to imagine anything other than a retailer that could be doing that.

Thanks to everyone who sent in an intrinsic value estimate. And especially to people who emailed me their analysis of the stock.

The one thing Id like to stress for everyone is that you can do more to learn about competitive advantages just from the financial statements. You dont just read financial statements to find out what earnings, book value, and EBITDA is so you can slap a multiple on that.

With 10 years of financial data, you should be able to learn a lot more about the business.

Warren Buffett has said that he used to do all the Phil Fisher type scuttlebutt work on competitive advantages when he was younger. But now he mostly gets it all from reading. Especially from reading the SEC reports.

He does that by letting numbers tell him a lot more than just growth rates and earnings multiples. He looks at things like the 10-year record of gross margins. He looks at things like how cheaply Wells Fargo is getting its deposits. These things are right there in the reports.

Financial statements tell a story.

Accounting is the language of business. And a lot of the description of a company and its competitive advantages isnt in magazine articles and CEO interviews and business descriptions its right in the balance sheet, income statement, and statement of cash flows.

Especially when you can line up 10 years worth of those statements and see how they relate to each other theres a lot of business description in the financial data.

Usually, a good analysis of a competitive position depends on combining what you see in those statements with some stuff that isnt in the statements. But it rarely comes just from stuff that isnt in the statements.

So even when you get a 10 year financial summary without a company name, industry, etc. you can still start by looking at it like a business analyst not just a stock analyst.

By the way, here are Wal-Marts annual reports for the last 40 years.


Visit Geoff at Gannon On Investing

About the author:

Geoff Gannon

Rating: 3.3/5 (43 votes)


Balajisridharan - 8 years ago    Report SPAM
Great article!! Learnt quite a bit!!!
Blainehodder - 8 years ago    Report SPAM
Professor Gannon, great post as usual!!! I give myself a B+ grade for my response! Thanks as usual for the lesson!

I thought a buyer could get aggressive, but did I potentially miss the mark in arguing you need to assess the qualitative factors to justify a high purchase price? I still think that a qualitative assessment increases your margin of safety...but maybe I went overboard on the scuttlebutt factor.

I concluded 16 x earnings would be fair with the qualititative assessment, great businesses command fair prices, and the moat would have provided the margin of safety! The real question is whether I would have assumed the qualititative assesment of WMT warranted the purchase! Since I think it traded at 30 bucks in 1981 (as per a quick glance at the annual report), it looks like I would have bought!

I wrote:

Buffett would be willing to pay up if he had a conviction in the moat, as that is where his margin of safety would be.


This looks a lot more like a late Buffett/Munger/Fisher style stock pick, and as such it is really a call on the business moat. This looks like an extraordinary company, and should therefore command a fair price, assuming your conviction is high in its durability. If you can get a bargain, great! For long run holders however, your returns on the stock will likely be determined by your assessment of the moat's durability, not whether you paid 12 instead of 16 times earnings. If you actually believed earnings growth and returns on tangible equity was sustainable, you could prob pay 25x earnings and still crush the market...That would be a very bold assumption though.


I'd pay:

105,000,000 x .64 / 32,324,445 = 2.07 EPS

2.07 *14 or 16 = $27-$33

Oh and here is your lie:

"Do you need anything else?

I dont think so."

I do. I think I need to assess the franchise durability, and I'm not sure I can do that effectively on just the numbers.

Looks like I may have picked it up! No need for disappointment!

Also Check out CSinvestors article on 80s WMT here!!!!

Theredcorner - 8 years ago    Report SPAM
Looks like the goalpost was moved. Was "how much would you pay?" and is now "What's the intrinsic value?".

The qualitative strength of a business's competitive position and the size of its addressable market is never revealed by its financials alone.

Buffett may not have done any scuttlebutt work on this but he knew he was looking at a low cost general retailer with a very large addressable market and he knew why it was earning economic profits. In that regard, there's a difference between Walmart in 1981 and, for example, Coach in 2002, even though they are both retailers and even though their financials are in other respects very similar -- i.e. growth akin to biological replication and eerily stable margins.

Alice Shroeder reports Buffet as having been willing to pay a price that will give him a 15% yield that will compound from there. That's what he paid for Mid-Continental Tab Card, for example. Using that rule of thumb on Wal-mart would have put his buy price in the $20-25 range.

And it turns out that the market price of the common stock ranged from $13.88 to $35 in 1981, mostly clustering at the $20-$25 range. That's probably what he paid. Did he think it was worth more? Obviously.
Ankitgu - 8 years ago    Report SPAM
Not to disagree, but Coke's value may be in something other than the product itself. The product was just a great way to build a company, because I think Coke would be just fine today if everyone stopped drinking Cola's 10 years from now. The idea is that they have moats around production costs and distribution - no matter what people drink, they will drink something, and so if they drink a Coke distributed product, Coke essentially ends up with a royalty on gulps and sips. Without a patent.

The biggest challenge with creating a beverage company today is distribution, and it's why you see so few of them. It's also why Pepsi/Coke can buy companies at very high multiples - they know that when they plug the acquired firm into their distribution system, they'll earn 10x what the company was earning before due to this scale.

Colas today, in and of themselves, are no mystery. It's mostly just lime and cinnamon - pepsi has more lime and coke has more cinnamon. On average, coke drinkers like slightly spicier foods for this reason.

Pepsi seems to have picked up on this distribution advantage really well and applies it to others products. I have no idea if it truly creates synergies or not, but they've pulled it off really well so far.
Sobko - 8 years ago    Report SPAM
Ben Graham:

'But it is of the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation.

'We would suggest that about sixteen times average earnings is as high a price as can be paid in an investment purchase in common stock.

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