Casestudy: Walmart Annual Report

Executive Summary

The report delves into the intricacies of the Walmart annual report and intends to highlight the difference between the intrinsic value and market price of the shares of Walmart. The market price is compared with the financial data values to arrive at the intrinsic value and reasons for such differences were stressed upon. The results imply that Walmart are trading at a lower price as compared to its intrinsic value therefore they can be recommended as a good buy as the market price will eventually correspond to the intrinsic value. The company is following a supernormal period of growth implied by the higher growth rate of dividends which are likely to continue for a few upcoming years. The credit analysis of the company is made employing the solvency, coverage and capitalization ratios which indicates the financial strength of the company. However, there are some corporate governance issues which the shareholders have been raising their voicing since the last couple of years.

 

Part 1: The Valuation of the company using the Discounted cash flow model and Residual Earnings approach.

 

1.1 Introduction

Wal-Mart stores which is famous by the brand name of Walmart is an American retail corporation which is running chains of large discount departments and warehouse stores all over the world. According to the fortune global 500 list, it was termed as the world’s largest public corporation, the biggest private employer in the world employing more than two million employees and is no doubt the largest retailer in the world. Considered as one of the most valuable companies of the world, it is controlled by the Walton family who owns more than fifty percent of the shares. Walmart has over 11,000 stores in 27 countries, under 55 different names.(Wal-Mart locations, 2014).

Walmart operates in an industry which is highly competitive and it is a well known fact that the consumers like bargaining. When one gets more for less money is considered to be shrewd shopping which is the prime strategy of Walmart. It has opted to ensure that the prices remained low increasing the purchasing power of the consumers instilling them with the feeling of fulfillment which benefits both the consumers and the economy resulting a win, win situation for Walmart stores.

Its competitive environment is unique in nature. Most of the competition comes from general merchandise retailers, warehouse clubs and supermarket along with the retailers. Wal-Mart’s primary competitors are Target and Kmart. Retail superstores such as Circuit City and Bed, Bath, and Beyond, also provide retail competition. The primary attributes on the basis of competition is the needs of the customers. In the warehouse section, it competes with Costco which has fewer warehouses but large revenues as it offers more innovations such as luxury items and was the first to sell fresh meat. Differentiation also serves as the major factor for attracting consumers. Its position is strong as the rivalry among the competitors is weak. Walmart has the lowest cost, prices profits and market share while it makes a great deal of effort of being innovative and meeting customer demands. (Hayes, 2007)

 

1.2 Valuation of Walmart

Valuation of the company can be termed as the heart and soul of finance. In corporate finance, the whole story revolves around the increase in the value of the firm through investment, financing and dividend decisions. There are various models for valuation of the companies. The most commonly used methods that will be discussed in this paper will be the discounted cash flow valuation method and the residual income valuation method.

 

1.3 Discounted Cash Flow Valuation Model

In using discounted cash flow methods, the value of an asset is the sum of all present values of the future cash flows of the assets which are discounted at the rate which implies the riskiness of these cash flows (Bagwell and Shoven, 1989) This approach is the most preferred one as it explicitly states the primary reason behind the buying of any security, the cash flows. Assets which have higher cash flows will have higher value and vice versa. While valuing the equity of a company, the two sources of cash flows are important. One is the cash flow in the form of dividends and the other is the free cash flow to the firm (Buerkle, 1999)

 

1.4 Dividend Discount Model for Walmart

The value of the stock is calculated as follows:

The dividends growth rate for the application of this model can be calculated using the following formula:

G= Profit Margin x Retention Rate x Assets Turnover x Total Leverage

Selected Financial Data (All figures in million)	2010	2011	2012
Cash dividends declared	4,217	4,437	5,048
Consolidated net income	14,335	16,389	15,699
Net sales	405,045	418,952	443,854
Total assets	170,706	180,782	193,406
Total Walmart shareholders’ equity	72,929	71,247	75,761
Profit Margin	0.035	0.039	0.035
Retention rate	0.706	0.729	0.678
Assets turnover	2.373	2.317	2.295
Total Leverage	2.341	2.537	2.553
Growth rate for Dividends	0.138	0.167	0.141

 

To calculate the required rate of return on equity, the following assumptions are made in this context.

• The risk free rate is equal to the un-weighted average of bid yields on all outstanding fixed-coupon U.S. Treasury bonds neither due nor callable in less than 10 years (risk-free rate of return. It is used as a proxy for the risk free rate.
• The expected rate of return on the market portfolio is equal to the return on S & Poor 500 index for the year 2010 i.e. 12.78
• Beta measures the portfolio sensitivity of its returns on the “market portfolio” of risky assets. Systematic risk (β) of Walmart’s common stock: βWMT =0.37
• The required return on equity can be calculated as follows:

Ke = rf + ( Rmp – Rf) β

Ke= 3.34 + (12.78 – 3.34) 0.37

Ke= 6.83 %

In the above case, it is evident that the growth rate of the dividends is greater than the required rate of return at present. This implies that the company is growing more than the rate of the whole market which is impossible to exist in perpetuity therefore this approach cannot be used for valuation of Walmart. In this context, the free cash flow to the firm is more appropriate. (Fama and French, 1999)

 

1.5 Free Cash Flow to the Firm

Free cash flow to the firm (FCFF) is cash flow which is available to all suppliers of capital for a firm after the firm has paid off all its operating expenses, taxes and capital expenditures required to sustain the productivity of the firm. A way of calculating free cash flow is as under:

FCFF = CFO + Interest (1 – Tax Rate) – FCI

All figures in millions.

Free Cash Flow to Firm (FCFF)	2008	2009	2010	2011	2012
Cash Flow from Operation (CFO)	20,642	23,147	26,249	23,643	24,255
Interest ( 1 – tax rate)	1,220	1,292	1,281	1,363	1,469
Fixed Capital Investment	14,937	11,499	12,184	12,699	13,510
FCFF	6,925	12,940	15,346	12,307	12,214
Growth Rate		87%	18%	-20%	-1%

 

The value of the firm can be calculated using the following formula

Terminal Value of Firm= FCFF / WACC

However, the growth rates (g) mentioned above are actual growth rates in the free cash flow to the firm.

For the Calculation of WACC

All figures from the annual report are in millions

 

Projected values of FCC

FCFF	2008	2009	2010	2011	2012
FCFF	6,925	12,940	15,346	20,158	24,369
Growth rate		1.869	1.186	1.314	1.209
		86%	18%	31%	21%

 

It is assumed that the firm ends its period of supernormal growth and continues to grow at same level in the upcoming years for perpetuity.

 

Intrinsic Value of Walmart	2010	2011	2012
FCFF	$15,346	$20,158	$24,369
WACC	5.63%	5.15%	5.58%
Firm Value (FCFF/WACC)	$272,575	$391,418	$436,720
Debt Value	$33,231	$40,692	$44,070
Equity Value	$239,344	$350,726	$392,650
Number of Shares	3,925	3,516	3,418
Intrinsic Value per Share	$60.98	$99.75	$114.88
Actual Market Price	$53.93	$58.37	$69.95
Market Under/Over Valued	Under Valued	Under Valued	Under Valued
Under Valued By	$7.05	$41.38	$44.93

 

The above analysis gives the share price value $114.88 in 2012 which is $44.93 more than as compared to actual share price ($69.95) in 2012. Share price was undervalued by $7.05 and $41.38 in 2010 and 2011.The higher share price (Intrinsic Value) also revealed that there is potential to grow the share price in the future and valuation model is based on free cash flow which is less likely to manipulate. In spite of this model has some limitation, but still free cash flow valuation model is considered as one of the best valuation model as compared to other valuation model.  Therefore, based on the free cash flow valuation model, it can be said that the share price of Walmart is fairly undervalued by the market.

 

1.6 Residual Income Valuation Approach

Residual income is termed as the net income of a firm less the charge that is equivalent to the stockholders opportunity cost of the capital. The rationale behind this residual income approach is that it incorporates the effect of cost of equity in the measurement of the income. Subsequently, residual income takes into account all capital costs. The valuation of the intrinsic value of the stock can be calculated using the following formula:

Vo = Bo + ((ROE – r) x Bo))/ r – g

Where Bo = Book value of the share

ROE = return on equity

R = required rate of equity

G = growth rate

The above mentioned formula states that if the return on equity is equal to the required rate of return on the equity then the value of the share will be equal to its book value while the additional part implies the additional value generated by the firm to produce return in excess of the cost of equity. (Lintner, 1956)

The following table represents the calculation of the intrinsic value of the shares of Walmart. The book value is calculated by dividing total equity by total number of shares while the growth rate is calculated by multiplying the retention ratio with the return on equity. Then the above formula is used to arrive at the intrinsic value of the share.

 

Order Now

All numbers are in Million	2010	2011	2012
Total Equity	70,749	71,427	75,761
Number of shares	3,925	3,516	3,418
Book Value	18.03	20.31	22.17
Re	6.83%	6.34%	7.05%
Net Income	14,335	16,389	15,699
ROE	20%	23%	21%
retention ratio	0.71	0.73	0.68
Growth rate	0.14	0.17	0.14
Vo	53.42	73.47	65.10

 

 

1.7 Comparison of the both methods

The primary reason for using the dividends in the valuation of the company is based upon the fact that the shareholders investment today is worth the present value of the future cash flows that are expected to arrive in the upcoming years. Furthermore, dividends are considered to be less volatile than earnings or cash flow. Hence the value derived from dividend discount model is less volatile and reflect the long term earning potential of the company. (DeAngelo& Skinner, 2004).

However, it is difficult to measure value in the case of companies who do not pay dividends and this approach takes the perspective of an investor that holds a minority stakein the firm. In contrast, the free cash flow model can be applied to various firms regardless of their capital structures and dividend policies. The concept of free cash flow is more pertinent to the firm stakeholders i.e. the debt holders and the shareholders (Ohlson, J. 1995).However, the free cash flow is negative for the firms who have significant capital requirements for running the operations of the business. It is readily applicable to those firms with cash flows that align with their profitability and when the perspective of a controlling shareholder. The advantage of using this valuation is that the detailed analysis and values of the balance sheet and the income statement is made which includes all the inflows and outflows of the funds. In this way, all the real balances are used to project a balance which will be used to predict future growth. Consequently, the estimates made on the basis of free cash flow contribute to more accurate and realistic value of the company.

In both the above mentioned cases, residual income approach can be applied to both the companies with no dividend history and with negative cash flows. However, they require an in depth analysis of the firm accounting accruals. The discretion of the management in establishing the accruals for both income and expense may obscure the results for the period. It is more useful when the reporting of the firm is transparent and earnings are of high quality. (Penman andSougiannis, 1997) However, the major drawback of this approach is the fact that it relies so much on the forward looking estimates of financial statements which results in the biased forecasts caused by psychological biases or misrepresentation of the firm financial statements.

 

Part 2: Credit Analysis of Walmart

Credit Analysis is done with the perspective of the firm’s ability to generate sufficient returns to satisfy both the shareholders and debt holders. It can only be done when the firm implies strong financial position to pay interest to the debt holders and sufficient returns which will cause the stock price to rise. Keeping this fact in view, the most important ratios are the solvency ratios, capitalization ratios and coverage.(CFAScheweser Notes, 2013)

Credit analysis usually revolves around two types of risk which are termed as the default risk and credit risk. Default risk implies that the company will not be able to meet payments on its debt obligations.  In order to mitigate this risk, lenders often charge a high rate for lending. The higher is the risk involved in the operations of the business, the higher the required rate of return will be and vice versa.

In the year 2013, Fitch ratings assigned a rating of AA to Walmart $1 billion issue of five-year notes and $750 million of 30-year notes. The Rating Outlook is Stable (Business wire, 2013). This was owed to the dominant position of Walmart in North America, a strong position in the UK and the openings of its stores in emerging markets such as China, Brazil and South Africa. These facts were also strengthened by Wal-Mart’s low cyclicality, the stable free cash flow over the last period of years and steady financial leverage. The following calculations will support this judgment.

 

2.1 Liquidity Ratios

A firm liquidity ratios deal with the question whether the firm will be able to meet its short-term obligations as they will come in the upcoming year. The two commonly used ratios to test the liquidity of the company are current ratio and the quick ratio.

2.1.1Current Ratio

The current ratio is the best indicator of the extent that the short term claims of the creditors will be covered by the short term liquid assets of the company i.e. the assets which are readily converted into cash (Brigham& Houston,2009). This ratio is the most common used measure of short term solvency.

2.1.2Quick Ratio

Quick Ratio is calculated by deducting inventories from current assets and dividing by current liabilities. (Brigham& Houston, 2009).  Inventories are considered the least liquid as in case of a bankruptcy, they are most likely to suffer losses. Therefore, this ratio implies the ability to pay short term obligations without relying on the inventories. The following table shows the liquidity condition of Walmart Company.

 

All numbers are in million	2012	2011	2010
Current Assets	54,975	52,012	48,331
Current Liabilities	62,300	58,603	55,561
Inventories	40,714	36,437	33,160
Current Ratio	0.88	0.89	0.87
Quick Ratio	0.23	0.27	0.27

 

As expected the company maintains a high current ratio but since the strength of the company is through sales of inventory therefore the liquidity without the inventory is very low. The results are characteristics of a retail store company. Companies with a greater short term solvency ratios than the industry average are in a better position to pay off short term debt.

Taking a glance at Walmart reveals that the company is not in trouble as implied by the current ratio. A current ratio of 0.88 implies that the company is able to pay 0.88 cents for every $ 1 of liabilities. Coming to the quick ratio, it is more indicative of the liquidity of the company as it excludes the inventories from current assets as the inventories generally take more time to be converted into cash. In order to convert them into cash immediately, the company must have to receive a lower price as compared to the market value of the inventory. From the above calculations, it is observed that Walmart maintains a quick ratio of 0.20 which implies that the company only has $ 0.20 for every $ 1 of current liabilities. This fact is quite alarming as it implies that the company does not have enough funds available to meet short term liabilities for its creditors and continuing in the future would more likely result in a threat of bankruptcy.

 

2.4 Capitalization Ratio

Capitalization ratio is evaluated with reference to the industry in order to determine the firm’s ability to take on additional risk, which is associated by additional borrowing. Companies with higher capitalization ratios will have less capacity to take on more long term debt. The ratio which commonly used is total debt to Capitalization ratio.

 

All numbers are in million	2012	2011	2010
Long Term Debt	44,070	40,692	33,231
Current Liabilities	62,300	58,603	55,561
Total Equity	75,761	71,427	70,749
Total Debt to Capitalization Ratio	0.58	0.58	0.57

 

This Total debt to Capitalization Ratio implies the financial leverage of the firm calculated by dividing the total debt (long-term and short term) of the company by the amount of capital sources available. Since Walmart do not have any minority interests and preferred equity shares, therefore it is calculated using total equity and total debt. This implies the value of leverage used by the Walmart which amounts to nearly 57 %. This states that for every $ 1 of assets, 0.58 cents have been obtained through borrowing. This implies that the company of Walmart is riskier as compared to the companies in the industry as it utilizes a large amount of debt.

On the other hand, it can also be said that company manage its debt level very well as debt level is similar over the last three years and it seems that company has a predetermined strategy to use larger debt amount as compared to total capital sources. This high capitalization ratio also helps to increase shareholders return because of tax shield of debt.

2.5 Coverage Ratios

Coverage Ratios measure the ability of the firm to repay its debt and lease obligations out of its operating cash flows. The most commonly used ratios are EBIT coverage ratio and EBITDA coverage Ratio. Companies with stable, comfortable ratios are highly preferred and are more credit worthy. CFA Scheweser Notes, 2013

All numbers are in million	2012	2011	2010
EBIT	26,558	25,542	24,002
Annual Interest Expense	1,884	1,900	1,794
DA	8,130	7,641	7,157
EBITDA	34,688	33,183	31,159
EBIT Coverage Ratio	14.10	13.44	13.38
EBITDA Coverage Ratio	18.41	17.46	17.37

 

From the above table it is evident that Walmart is maintaining a healthy strong cover for the payment of its debt holders. The earnings of the company are enough to give the lenders significant satisfaction in the form of a healthy cover. Despite total debt increase than the last year, company still able to increase its coverage because of excellent earning generating ability. It should be noted that interest expenses in 2012 is lower than 2011, it seems that company looks to reduce its interest bearing debt level (long term debt) and increase non-interest bearing debt (current liabilities).

 

2.6 Corporate Governance Policies

According to CFA institute, corporate governance refers to the system of policies, procedures accompanied by the accountabilities and responsibilities used by the stakeholders of the organizations to overcome the conflict of interest present in the structure of corporate firms. In short, the system of corporate governance affects both the operational risk and value of the companies. Effective and strong corporate governance is essential for the efficient functioning of the markets.

There are some corporate governance issues which are taking place at Walmart. A strong corporate governance practice is the independent directors in the boards of the company. In the case of Walmart, family of Sam Walton who is the founder of Walmart Inc owns more than 50% of the shares.The institutional investors are expressing the concern that the family is allowing the minority of independent directors on the boards. Due to the recent buy backs, the founding family stake has now increased to more than 50 % as compared to the last year figure of 39 % (Bloomberg, 2013). Under the rules of the New York stock exchange, when the company owns more than 50 % of the shares then it can be classified as the controlled company and it can choose to opt out of the requirement of the independent directors on their board.

However, the company has said that they do not intend to do so. In direct contradiction of this statement, the company is losing three of its board members out of its 17 that will reduce the percentage of independent board members from 71 % to 64 %. It is also worth mentioning that 7 of the 9 independent directors have outside financial ties to the company. The company five non independent directors include the founder eldest and youngest son and his son in law. Recently the company paid $29.4 million in fiscal 2013 to Cheyenne Industries Inc who is owned by the son of present non independent board member Mr. Scott.

Wal-Mart paid Saatchi & Saatchi $198,000 for marketing services. Brittany Duke, the daughter of Wal-Mart CEO Michael Duke, is an executive officer at Saatchi. Stephen Weber, a senior manager in IT at Wal-Mart, was paid $167,869 in salary and benefits in 2012. Weber is Michael Duke’s son-in-law. His bonus alone of $32,024 is 40% more than the average Wal-Mart worker in Texas makes in a year.Arne Sorenson, the CEO of Marriott International, is also a director at Wal-Mart. Sorenson’s company received $19 million from Wal-Mart in 2012 for “hotel, lodging and related services.”(Huffington Post, 2013)This implies that the company is experiencing the conflicts of interest’s problem and shareholders are now voicing their opinions. In terms of corporate governance, such transactions can be duly justified, but from an ethical perspective, it is creating doubts in the minds of the shareholders.

 

2.7 4 Cs of Credit Analysis

The CFA institute defines the 4 Cs of credit analysis, which comprises of Character, Capacity, Collateral and Covenants. Character defines the quality of management and willingness to pay its debts. Capacity refers to the ability of the borrower to meet its obligations. Covenants are defined as the terms and conditions stated in the bond agreements while collateral refers to the quality of value and assets supporting the debt. In the case of Walmart, the company is not likely to meet its debt obligations which are implied by the low quick ratio. A demand from creditors will force the company to readily convert its inventory into cash will be done at a lower price as compared to the market value.  This explains that the company has a low capacity. In the context of bonds, they are highly rated by the government agencies implying that they are sufficiently backed by assets. The management is also facing some ethical issues implied by the shareholders concern over the less independent board.

 

Conclusion

The above mentioned ratios imply that Walmart is operating soundly in terms of the current ratio but when it comes to the quick ratio the results are deteriorating as implied by the fact that the companies cannot convert inventories readily into cash. . The company is maintaining a low-level of liquidity which is quite unsatisfactory. No doubt the debt ratio is high which is balanced by the high level of coverage ratios. All these six ratios calculated above depicts the liquidity position of the company, the level of debt and the coverage of the interests which gives an overall position of the company. Furthermore, the conflicts of interests that have arisen as the shareholders are expressing their voices as some transactions are being made which are not ethically justified.

 

 

References:

1. “Walmart Corporate: Locations”. Walmart. Retrieved April 2, 2014.
2. Hayes, Thomas C. (February 26,2007). “COMPANY NEWS; Wal-Mart Net Jumps By 31.8%”. The New York Times.
3. Buerkle, Tom (June 15, 1999). “$10 Billion Gamble in U.K. Doubles Its International Business: Wal-Mart Takes Big Leap into Europe”. International Herald Tribune.
4. Bagwell, Laurie Simon and John Shoven, 1989, “Cash Distributions to Shareholders,” Journal of Economic Perspectives Vol. 3(3), pp. 129-40.
5. Fama, Eugene F., and Kenneth R. French, 1999,”The Corporate Cost of Capital and the Return on Corporate Investment,” Journal of Finance Vol. 57, pp. 637-659
6. Lintner, J., 1956, “Distribution of Incomes or corporations among dividends, retained earnings and taxes”, American Economic Review 46, pp. 97-113.
7. DeAngelo, H., L. DeAngelo, and D. Skinner, 2004, Are dividends disappearing? Dividend concentration and the consolidation of earnings, Journal of Financial Economics, v72, 425–456.
8. Ohlson, J. 1995, Earnings, Book values and Dividends in Security Valuation, Contemporary Accounting Research, v11, 661-687.
9. Penman, S. and T. Sougiannis, 1997. The Dividend Displacement Property and the Substitution of Anticipated Earnings for Dividends in Equity Valuation, The Accounting Review, v72, 1-21
10. Walmart Annual Reports 2010, 2011 and 2012.
11. Fundamentals of Financial Management (10^th edition)By Eugene F. Brigham, Joel F. Houston.
12. CFA level II Scheweser Notes.
13. http://www.businesswire.com/news/home/20130926005993/en/Fitch-Rates-Walmarts-1.75B-Bond-Issue-AA#.Uzz-7fmSzh4
14. http://www.bloomberg.com/news/2013-06-06/wal-mart-board-seen-at-risk-of-losing-independent-voices.html
15. http://www.huffingtonpost.com/al-norman/walmart-at-50-a-crisis-of_b_1489776.html