Valuation and Creditworthiness Evaluation of Wal-Mart Stores - Case Study Example

Valuation and Creditworthiness Evaluation of Wal-Mart Stores, Inc. of Part Valuation of Wal-Mart Stores, Inc. 1. Introduction This paper aims to do valuation for Mart Stores, Inc. (WMT) using Residual Earnings Analysis (REA) and Discounted Cash Flow (DCF). Afterwards, a backward validation will be done to discover the usefulness of two valuation techniques, by comparing the latter’s respective ex-post estimates of the fundamental (intrinsic) value of the firms equity with the actual market price of the equity as of end of December, 2010. 1.2 Company Background Wal-Mart Stores, Inc. (WMT) is well-known US Company that operates many retail stores using several formats in many countries of the world. It operation basically uses three segments which include Walmart U.S., Walmart International, and Sams Club (WMT, 2014a). The retail industry, where it belongs, is dependent on other industries like manufacturing on the basic premise what can the company sells come from these manufactured products. WMT is facing normal uncertainties in the US economy and the world, including international risks because of its wide scope of operations. WMT has been in business in many years with the model of s helping customers save in an industry where there is very strong competition. Such a philosophy of realities of spending from customers in relation to the business model of the company, its only expected that prices are reasonable and within what the competition allows while the company earns profits and stays in business with a strong degree of stability and sustainability (Wal-Mart Store, Inc. 2014a). Several of other risks faced by WMT always include the continuing government budget deficit, employment conditions, economic disruptions brought by the sovereign debt crisis and other volatilities in the economy economic instability, changes monetary in the monetary policies of US Federal Reserve, and even from other governments where it conducts its business (Wal-Mart Store, Inc. 2014a). 2. Valuation 2.1 Cost of equity/weighted average cost of capital computation for WMT The two methods that will be used for the purpose of this paper requires the use of cost of capital As such there is a need to compute weighted cost of capital (WACC) for WMT is essentially for valuation purposes to determine the intrinsic value of the company. This intrinsic value is the one that will compared to market or current price of its stocks in the market. A that fully financed with equity, would not require to compute for the weighted cost of capital since the cost of equity would suffice. The Capital Asset Pricing Model (CAPM) is used her to compute for the cost of equity under a given formula. The formula is: Required (or expected) Return = RF Rate + (Beta * (Market Return - RF Rate)), where RF stands for risk free rate and the rest of the formula is the market risk premium (Brigham and Houston, 2002). WMT would have a cost of capital at 6.47% if the formula is applied as follows: Required (or expected) Return = RF Rate + Beta (Market Return - RF Rate) = (0.5%)+(1.06*(6.47%-0.5%)) The risk free rate of 0.50% is taken from the latest UK base rate (Housepricecrash, 2014). The market rate of 6.47% is taken from the reciprocal of 15.44 low higher average P/E for five years of WMT while the industry beta of 1.06 is given (Reuters, 2014b). The industry beta was taken to be conservative and the company beta was only 0.45 (Reuters, 2014b). Since the company is not fully financed with equity as evidenced by presence of debt or liabilities in its balance sheet there is need to get the WACC. The WACC is computed at 4.75% using the formula below that considers aimed capital structure of the company from 2010 balance sheet. WACC=Ke*E/(E+D)+Kd*(1-t)*D/(E+D) Ke above represents the cost of equity while Kd is the cost of debt which stands at 1.7% as taken from interest expense in relation to net noncurrent liabilities. The tax rate assumed is 30%. E is book value of equity and D book value of long term liabilities are taken from 2010 balance sheet. 2.2. Valuation using Residual Earnings Analysis Residual earnings analysis, also called Residual Income Method (RIM), requires the present value of the residual income, in order to arrive at intrinsic value using this model. Residual income is the excess of Net Income after deducting equity charge (Brigham and Houston, 2002). To compute for equity charge there is need to multiply the cost of equity by the recorded book value or total stockholder equity in the balance sheet as of December 2010. Thus the equity charge for WMT would be $3,450 ($72,648 million x 4.75%). The WACC as computed is used Table A, as shown below, details the valuation using this REA. Note that the residual income of WMT is derived after the equity charge from the net income. The average residual income has to be discounted using the cost of capital at 4.75% to bring a valuation of $278,720.42 million. Afterwards, there is need to adding to this amount to the book value as of 2010 at $72,648.00 million, and the result is total valuation is arrived at $351,368.42 million. The valuation per share or intrinsic value of $90.89 per share as computed by dividing the said total valuation by the 3,686 million outstanding shares of stock as of 2010. Table A- Valuation under REA (Wal-Mart Stores, Inc. 2014a, 2014b, 2014c). See Financial Statements from Annual Reports for 2010, 2011 and 2012 as per Appendices A1 to C2). Comparison with the actual price per share of $53.93 (Reuters 2014b), would now be possible and this produces an undervaluation of $21.99 per share using the Residual REA or RIM. Note that the values for 2011 and 2012 are averaged to be the projected for the annual net income, which will be assumed to be realized in perpetuity. 2.2 Discounted Cash Flow Method DCF model is the other method to be used to validate the current price per share as of December 2010. Said model assumes that WMT will indefinitely generate cash flows in the operation of the business. Said operation also includes financing activities and investing activities of company in order of company to meet is financial or economic objectives of producing shareholder value (Brigham and Houston, 2002). Under the DCF used for WMT, certain assumptions are necessary as this would look involve also looking into the future. Sales revenues would be assumed to grow yearly in a constant manner at a rate of 4.5% per year. Given the targeted revenues per year, operating margin would be assumed to be consistent through the projected years. The assumption in relation to sales would go through with tax rates which are also assumed to be constant for the number of years ahead. Capital investments and working capital are needed to produce sustained level of revenues. Thus for the purpose of this paper, they would likewise be assumed to increase over time in relation to the increased level of operation at certain points time increased revenues are projected (Brigham and Ehrhardt, 2010). From the stream of cash flows or benefits are generated, the next step is to bring them to their present values by using a discount factor using the weighted average cost of capital the computed cost of capital at 4.75% WACC as computed earlier. A projected income statement with the effect of projected cash was prepared for the next eight years in the life of WMT is shown in Appendix F. In addition terminal values from ninth year and onwards were assumed to continue while the growth of revenues was assumed to 4.5% per year based on past experiences from year 2011 to eighth year. Given the mentioned assumption of the constancy of operating margin the operating costs and other subsequent items of cost and income are projected with the revenue increases. These costs of operation normally include, the payment for its employees ‘salary, the cost of operations supplies used, repair cost of important properties, and the costs of maintaining of the assets used in business. As computed under the DCF model, the price per share of WMT stocks has an intrinsic value of $802,771.23 million. See Appendix F. 3. Conclusion The current price per in the stock market is share as the December 10, 2014 was US53.93, while the computed market value per share using the DCF is $207.65 and $90.89 under REA. There is therefore higher overvaluation of under DCF method compared with REA As to which of the two approximates the correct will generally depend on assumptions of the model. However, if the closeness of the values realized from the model is used, REA produces a closer one and may indicate some validity. It may be recalled that only two years residual incomes with the remaining years in the future assumed to produce similar income in perpetuity were considered in effecting the REA method while under DCF there are 8 years projection and ninth year to perpetuity into the future, Therefore changing the assumptions would change resulting values change together with the applicability of the valuation method. If the current price of WMT as of April 2014 at 73.81 $per share at the time of this writing is used as point of reference it would appear that the undervaluation under the REA was more reliable. One imitation of the REA like the non-use of cash flows may however pose as consideration in accepting its result. It is however simpler to use compared with DCF. Part 2 - Credit Worthiness of Wal-Mart Stores, Inc. 1. Introduction Creditworthiness is a must for corporations if they have to maximize profits as to borrow is to be able to finance it operating and long-term capital needs if stocks are not issued or sold to generate cash. This part will evaluate the financial status of WMT as a potential corporate borrower, using as bases for four groups of ratios extracted from its financial statements for the years 2010, 2011 and 2012. The analysis will focus specifically on WMT’s ratios on short-term liquidity, long-term solvency, in relation with its and operating profitability and efficiency as a way to know its credit worthiness or capability to pay its debts on scheduled times over the coming future period. 2.1 Profitability and efficiency A debtor company that can show to the creditor that it can pay would have better chances of convincing the latter to lend said debtor in addition of course to the requirement that the debtor must have the character or intention to pay back. Such is called creditworthiness. From the point of view finance creditworthiness is financial capability to pay. Any prospective debtor has the burden to prove such capacity first being profitable in order that it can be said to be capable of generating funds for the purpose. Funds or cash flow would generally come from revenues as the company makes deliveries of goods and services to clients. Profitability is required of every company for practical and legal reasons. It is a way to influence first the decision makers that these companies are capable to earn a satisfactory return on sales, total assets, and invested capital. However, the term satisfactory to may have a relative definition for different users of information. This makes relevant to under companies in relation to the industry they operate. Moreover accounting information must be reliable before financial information which includes the income statement, balance sheet and cash flow statements could be used for decision making. This is the purpose to require publicly listed companies to comply with in the financial reporting requirement under generally accepted accounting principles in the US or the international financial reporting standards (IFRS) for those in Europe (Kieso, et al, 2007). There are of course different ways to measure profitability and efficiency. These ratios include the gross margin, operating margin and net profit margin. In addition, the same can also be measure using return on equity (ROE) and return on assets (ROA). Profitability of WMT was observably maintained from 2010 compared to 2011 with gross margin the same at 26%. From 2011 a slight decreased by 1% was noted when it went down to 25%, thus posting a three-year average of 25%. The operating margin for three years was also maintained at 6% together with the net profit margin which was maintained at 4% for the each year from 2010 through 2012. See Table I below. Table 1. Financial Ratios (Wal-Mart Stores, Inc. 2014a, 2014b, 2014c; Reuters.com 2014 b).See Appendices D and E) The low margin that the company generates from customers is significant compared to industry averages of 41% gross profit margin, 15.07% for operating margin and 10.94% for net profit margin. See Table I above. This means that the company was fulfilling its commitment to customers in its business model by allowing them to save as there is only a small mark-up that the company put in delivering goods and services to its customers. However when it comes now to ROA and ROE, WMT overtook industry averages. This means that it may have maintained small margin but from the economic view point, it was able to employ more productivity compared to competitors as far as the management of assets are concerned. This is the meaning of having higher ROA then competitors despite having lower net profit margin. In terms also of higher ROE, it was able to deliver better to stockholders compared to its average competitors in the industry despite offering lower prices compared with them. This analysis must be taken into consideration in relation to the solvency ratio of the company as against industry averages. Operating margin is computed by deducting operating expenses from gross profit. There is growth in operating efficiency every year or the company was able to reduce operating expenses in relation to sales. Operating expenses may include those of salaries expenses, adverting and other marketing expenses, repairs and maintenance costs, depreciation expenses and cost of utilities including communications and electricity costs. From the operating margin, the next measure of profitability is the net profit margin, which is derived by adding or deducting non-operating income or expenses to the operating profit. These items include invest income, dividend income, interest income and interest expenses. Moreover, WMT‘s average return on equity (ROE) of 22.0% for the past three years from 2010 to 2012, shows almost double superior performance compared with the industry average of 14.57% for the past five years. An average of about 20% return on equity, although is so spectacular a rate to have or investors to see, as it would mean that for every US$100 the investors expect returns of about US$20 and the company actually offers more than that at $22. For bench marking purposes, using a risk-free rate of 0.50%, if money was invested in risk free investments at the United Kingdom (Housepricecrash, 2014), 22% is more than forty times said rate. While sitting down, and just enjoying vacation and not moving one’s money would be just earning 0.50% per year and if inflation turns to be higher, money in the bank is actually losing its value. But put it as WMT and you have in one year in gaining from investment what you may have in 40 years at the bank. From a credit worthiness point of view, WMT’s profitability more than qualifies it borrow if competitors in the industry are used as reference. WMT can raise its head high about its capacity to honor its obligations as its stockholders are more than compensated in using borrowings as a finance option to produce wealth. 2.2 Liquidity The short-term liquidity ratios used are the current ratio and quick ratios, which are determined from the financial statements. Liquidity indicates capability to pay a company’s currently maturing obligations. Computing current ratio uses current assets to be divided to current liabilities, while quick assets ratio is almost the same except that the inventory and prepaid expenses are being removed from the current assets to have a new numerator but the denominator is the same (Brigham and Houston 2002). As applied now to WMT, the computed average current ratio of 0.88 and average quick ratio of 0.26 for the years 2010, 2011 and 2012 indicate slightly lower liquidity than average competitors in the industry. Since both average ratios of the company and are below 1.0, the same may raise some doubt about is liquidity. However considering its being in the retail industry where money flows more steadily almost every day, the same is not still a problem as a current ratio is theoretically close to 1.0 which is indicative of capability to pay. Moreover, verification from the cash flow statements of the company proves its positive cash position for three years (Wal-Mart Stores, 2014a, 2014b, 2014c). 2.3 Solvency or Gearing While liquidity assures meeting current obligations, solvency shows long-term capacity of a company to keep up it constancy over longer years (Helfert, E. 2001). As a building wealth is meant to be done long-term, so is solvency determinable in the same context. Thus to measure the same there is need to relate the total debt to the total stockholders’ equity (Higgins, 2007). Name as the debt to equity, the formula is to divide total debt of the company to its total equity, implying how much debt the company has in relation to total investment from shareholder. The moment a company many good things should follow. It is sending a message of comfort or an assurance to investors including creditors that the company has the good chance to survive the long term. In other words, recovery of its long term investments would be easier to believe. Using such rationalization WMT‘s having a higher average debt to equity ratio for the past three years 1.48 as against 0.93 industry average indicates its more than riskier position as against its competitors. Will such risky position not make the company be still a candidate to borrow? It appears that its dangerous but by looking at the price earnings ratio, five-year low, of the company at 13.4 as against industry average of 13.1 the investors are more than willing to invest at the company’ stocks (Reuters, 2014b). Even the companys beta of 0.45, indicates that it faces a lower risk compared with competitors with beta average of 1.06 for the past five year (Reuters, 2014b). To be creditworthy then from a financial perspective is to consider the interplay of profitability, liquidity, solvency and investment ratios for the past three years. Using the all the ratios combined, stability of WMT for the last three years is evident which makes capable to pay its debts both in the short-term and in the long-term. 3. Conclusion The financial ratios as extracted and analyzed show ample evidence of WMT’s profitability, liquidity and solvency, although less superior than the industry only in terms of risk position. However, this high risky position based on gearing or solvency is still responded positively from the higher P/E of the company as against the industry, indicating that WMT is trustworthy to investors. Perhaps investors perceived that WMT is really helping customers to save by offering them lower prices and in maintaining this relationship, it long-term financial health from the point of view of creditors is still assured. Creditors can still trust WMT as it would be able to payback its obligations based on its financial capacity as determined from financial ratios for the past three years. References Brigham, E. and Houston, J. (2002). Fundamentals of Financial Management, London: Thomson South-Western Helfert, E. (2011). Techniques of Financial Analysis: A Mode. McGraw-Hill Education (India) Pvt Limited. Higgins (2007). Analysis for Financial Management, Eighth Edition. The McGraw−Hill Companies Housepricecrash (2014), UK Base Rate, Retrieved 25 April 2014 < http://www.housepricecrash.co.uk/base-rates.php > Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Reuters (2014a). Company Overview - WMT. Retrieved 25 April 2014 < http://www.reuters.com/finance/stocks/overview?symbol=WMT.N> Reuters (2014b). Industry Ratios. Retrieved 25 April 2014 < http://www.reuters.com/finance/stocks/financialHighlights?symbol=WMT.N> Wal-Mart Stores, Inc (2014a). Annual Report for 2012 of WMT. Retrieved 25 April 2014 < http://c46b2bcc0db5865f5a76-91c2ff8eba65983a1c33d367b8503d02.r78.cf2.rackcdn.com/93/a7/ff21a9764702bb5bc8271faacfeb/2012-annual-report-for-walmart-stores-inc_130221023846998881.pdf> Wal-Mart Stores, Inc (2014b). Annual Report for 2011 of WMT. Retrieved 25 April < http://c46b2bcc0db5865f5a76-91c2ff8eba65983a1c33d367b8503d02.r78.cf2.rackcdn.com/2b/16/fa19acd64b60b475e6efaa1013b3/2011-annual-report-for-walmart-stores-inc_130221022810084579.pdf > Wal-Mart Stores, Inc (2014c). Annual Report for 2010 of WMT. Retrieved 25 April 2014 < http://c46b2bcc0db5865f5a76-91c2ff8eba65983a1c33d367b8503d02.r78.cf2.rackcdn.com/6c/20/87b0b3df469ebee838a2630c2c1a/2010-annual-report-for-walmart-stores-inc_130221021765802161.pdf> APPENDICES Appendix A1. Consolidated Statement of Income, 2012 (Wal-Mart Stores, Inc. 2014a) Appendix A2. Consolidated Balance Sheet, 2012 (Wal-Mart Stores, Inc. 2014a) Appendix B1. Consolidated Statement of Income, 2011 (Wal-Mart Stores, Inc. 2014b) Appendix B2. Consolidated Balance Sheet, 2011 (Wal-Mart Stores, Inc. 2014b) Appendix C1. Consolidated Statement of Income, 2010 (Wal-Mart Stores, Inc. 2014c) Appendix C2. Consolidated Balance Sheet, 2010 (Wal-Mart Stores, Inc. 2014c) Appendix D – Summary (Wal-Mart Stores, 2014a, 2014b, 2014c) Appendix E- Formula used for Table 1 in relation to Appendix D) Appendix F- DCF Valuation (Wal-Mart Stores, 2014a, 2014b) Read More