Metric analysis

A metric to help avoid Walmart-like stocks in your portfolio

eel

Introduction

Walmart (New York Stock Exchange: WMT) recently announced a disappointing forecast that immediately sent the stock price down about -8%. But that’s not the worst for Walmart shareholders. The worst part is that Walmart is probably dead money for years to come for medium and long-term stock market investors, as has been the case for many years. In this article, I’ll share some basic techniques and metrics that will help long-term retail investors avoid stocks like Walmart and earn better returns.

I always like to start my articles by reviewing the results of any coverage I’ve had of a stock in the past. I’ve only written one previous article on Walmart stock, which was back on Nov. 19, 2019, titled “Walmart: A 10-Year Full-Cycle Analysis.” In this article, I tagged Walmart as a “strong sell” or “very bearish”. Here’s how Walmart shares have fared since then.

WMT vs. SPY Chart
Data by YCharts

Walmart’s severe underperformance was entirely predictable given its fundamentals at the end of 2019. But what’s remarkable and still actionable for investors today is that Walmart stock is still overvalued and likely to produce poor returns in the future.

Walmart’s recent underperformance is nothing new. In a decade that included one of the best stock market bull runs of all time, Walmart returned less than half of what the S&P 500 index returned.

WMT vs SPY Total Return Price
Data by YCharts

In this article, I want to explore and further explain some of the most basic investment principles I use to evaluate stocks like Walmart in hopes that other investors can use them as well and improve their returns.

Reputation and brand recognition are not sufficient reasons to buy a stock

One thing that continually boggles my mind is why investors would pay as much money as they paid for a slow growing company like Walmart. The only conclusion I can come to is that people recognize the brand, they know Walmart has been successful in the past, and it’s hard for them to imagine anything that could seriously hurt the business in the short term. It makes them feel comfortable owning the action, and they just ignore the valuation.

Let me explain why this is not the right way to invest in stocks if an investor wants good returns, but before I do that, I want to make a few things clear up front. The first is that I think Walmart provides a valuable service to consumers, and I’m a longtime customer (mostly of Sam’s Club). I spend over $10,000 a year at Walmart and Sam’s. I don’t have any kind of ax to grind with Walmart. But being a customer of a store and being a passive owner of a store are two very different things. As a potential owner, I have to pay a price for the business that is justified by the likely return on that investment.

So what’s the easiest way to think about our likely ROI?

In my opinion, if I bought the entire business for $100, how much money could I make in profit from this business over the next 10 years? In other words, if I put in $100, how much do I have 10 years later if I keep all the earnings from the business for myself.

The easiest way to estimate this is to look at earnings yield, which is the inverse P/E ratio, or E/P. The way to think about earnings yield is to think of it as dividend yield, only, with earnings instead of dividends.

Walmart Earnings Return
Data by YCharts

Right now, Walmart’s forward earnings yield is 5.29%, so if you pay $100 for Walmart, you’ll earn $5.29 a year on your investment if earnings never increased or decreases. If you do this for 10 years (10 x $5.29), you get $52.90 in revenue that you would collect from Walmart’s business in that decade. Thus, we would increase our investment by $100 to $152.90 over 10 years. If you plug those numbers into a CAGR calculator, you get a ten-year CAGR of +4.34%. This would be the expected compounded return on your investment if you bought Walmart at today’s valuation and kept all the earnings for yourself if those earnings remained the same for ten years.

I don’t know about you, but it’s a very poor performer and not particularly appealing to me. But, fortunately, this is not the end of the story. Higher quality companies will be able to increase their profits over time, so each year, in theory, profits will increase rather than remain static. For this reason, we must try to estimate whether profits will increase and, if so, by how much we think they could increase on average. To do this, I look at the past and see what kind of history the company has when it comes to earnings growth.

Walmart profit growth rate

QUICK charts

I have a few other factors that I usually control in my standard analysis (and you can read about them in my previous Walmart article if you’re interested), but in order to keep this explanation simple, I’m just going to take Walmart’s earnings growth rate over the past decade directly from FAST Graphs, which is circled in gold above. Walmart has increased its earnings per share by +3.21% on average since 2013.

Now let’s go back to the $5.29 per year that we will earn on our $100 WMT investment and assume that $5.29 grows by +3.21% per year for 10 years. I like to pull first year earnings growth forward to be generous. The table below shows how much money we would have accumulated after each year for 10 years.

Year Cumulative amount collected

1

$5.46
2 $11.09
3 $16.91
4 $22.91
5 $29.11
6 $35.50
seven $42.10
8 $48.91
9 $55.94
ten $63.20

Okay, whereas before, without revenue growth, we would have earned $52.90 over that period, because revenue was growing a little each year, we were earning $63.20. When we assume that $100 becomes $163.20 over 10 years and put that into a CAGR calculator, we get a 10-year CAGR expectation of +5.02%. And that’s what we expect from Walmart’s business performance if the next decade is similar to the last decade.

Investors should ask themselves if this +5.02% is an adequate return.

For me, I’m aiming for mid-term annual returns of 15% to 20%, so a likely 5% return isn’t very attractive to me, and at today’s price, I would never consider buy a stock with Walmart’s valuation. Importantly, as Walmart’s stock price declines, assuming earnings remain the same, the earnings yield will increase and the future returns the investor expects from the business will increase. So if Walmart’s stock price was, say, halved, then it would offer much more attractive potential returns.

So far, I’ve tried to simplify this valuation process to get the basics across as much as possible, but this basic valuation can be simplified even more by using a PEG ratio. Popularized by Peter Lynch, the PEG ratio takes the P/E ratio and earnings growth and converts them into a simple ratio. The lower the PEG ratio, the better the valuation, and generally a very good PEG ratio is considered 1 or less. Personally, I would consider a PEG ratio above 2 to be high, and if a PEG is above 3, that generally equates to a “sell” for me based on high valuation (which in turn equates to low yields future).

If we take Walmart’s estimated earnings for this year of $6.36 (which is probably optimistic given their recent announcement) which produces a P/E of 19.09, and if we divide that by the growth rate earnings of 3.21, we get a PEG ratio of 5.95, which is extremely high, indicating high valuation (and likely low returns).

For companies with relatively stable revenues like Walmart that have a long history of earnings, the PEG ratio is a very quick and easy way to spot overvaluation and undervaluation. The main thing an investor needs to be careful about is simply making sure that their assumptions about earnings and earnings growth are reasonable.

There have been alternative investments available

One excuse for investors holding slow-growing but expensive stocks, like Walmart, is that there has been no alternative (TINA as it is often called). The argument is that bond yields have been depressed over the last decade so even if Walmart returns 5% that’s better than bonds and at least Walmart can potentially pass some of the inflation on to consumers unlike to bonds. On the face of it, that seems pretty reasonable, but we also have to consider that, unlike bonds, there’s no guarantee that Walmart will actually achieve that 5% annual return. Sears and K-Mart were similar companies that couldn’t do that. So we take on more risk with Walmart to go along with the higher potential reward and inflation mitigation.

But the best response to Walmart shareholders is that there are similarly priced retail stocks with better earnings growth and, therefore, better PEG ratios. I will share two that I own. The first is Tractor Supply (TSCO).

Tractor Supply Revenue Trends

QUICK charts

Just using the basic information from the FAST chart without any adjustments, we have a P/E of 21.16 (about the same as Walmart) but earnings growth of 15.84%. That’s a PEG ratio of 1.34. Maybe not extremely cheap, like when I bought it in March 2020, but a much better deal than Walmart.

Next, let’s look at another of my holdings, AutoZone (AZO).

Auto Zone Revenue Trends

QUICK charts

In the case of AutoZone, it actually has a slightly lower P/E than Walmart, but it also posted 15.83% earnings growth, using only the base numbers from the FAST chart. This produces a PEG ratio of approximately 1.20. Again, maybe not cheap enough to buy on an absolute basis, but much more attractive as an alternative to Walmart stock.

Conclusion

Brand recognition and a reputation as a winner in distant history are never enough to offset valuations that are simply too high. Walmart could be around for decades and provide good value to consumers, but that doesn’t mean it’ll be a good investment for investors buying or holding stocks today. There’s really no reason to hold a stock like Walmart at these prices when there are alternatives whose futures are clearly superior and trading at better valuations once earnings growth is factored in. Forgetting about name recognition and taking a look at the PEG ratio will go a long way to improving returns for retail investors who own stocks like Walmart.