\fWalMart became a publicly traded rm in 1970 with an initial stock price of $16.50 per share and subsequently declared its rst cash dividend in March 1924 of $0.05 per share (after two twoforone stock splits). It had undergone 11 twoforone stock splits, and thus, an original lot of 100 WalMart shares had grown to 204,800 shares after the most recent split in March 1999. Analysts generally believed that Wal-Mart would continue to be successful in consistently increasing prots, and the consensus annual earnings growth forecast for the next ve years was 13.7'r percent. As of late December 2005, according to Bloomberg L. P., WalMart shares were ranked as \"buys\" in the coming six to 12 months by 15 analysts, \"holds" by 11 analysts, and \"sells\" by one analyst. These rankings (which amounted to an average of 4.00 on a vepoint scale) currently exceeded the average buyr'holdfsell mix among S&P 500 rms (3.64) and among retail stores (3.53). Analysts\" consensus projected WalMart's target price was $55.45, relative to a recent closing price of $49.47. However, over the past 12 months, WalMart shareholders had suffered a total return (including dividends) loss of 6.50 percent, and while the consensus stock price forecast ranking (as measured by buysr'holdsr'sells) was above that of the overall market, it was substantially down 'om the previous two years. WalMart's 52week high was $54.60 and the 52week low was $42.33. Martin noticed that 1WalMart shares had a price to trailing earnings (PIE) ratio of 19.3 times (based on the last four quarters of earnings) and an indicated dividend yield (based on the current quarterly dividend and current stock price) of 1.2 percent. Exhibit 2 presents a graph of WalMart's stock price for the past 10 years, while Exhibit 3 presents a summary of dividend payments since 1995. In determining whether Wal- Mart was fairly valued, Martin decided to focus on valuation concepts she had been introduced to in her university business courses and in one of her rm's training courses: the dividend discount model, the capital asset pricing model (CAPM) and pricefeamings multiples. DIVIDEND DISCOUNT MODEL According to the dividend discount model (DDM), the current stock price of WalMart represented the present value of expected future dividends, discounted at the investor's required (or expected) rate of return. In theory, one would need to anticipate future dividends in perpetuity or anticipate a \"liquidation\" or \"terminal value" date that would represent a nal dividend payment (for example, if a rm wound up business and returned a liquidating dividend). Alternatively, dividends could be estimated for a set number of years, at which point a future stock price could be estimated and treated as a \"terminal value.\" In such a model, the future stock price would represent the present value, at that point, of any future dividends beyond the terminal value date. For example, some analysts were expecting dividends of $0.64 per share in 2006, $0.75 in 2007, $0.85 in 2008, and $0.97 in 2009 and a 2009 stock price of around $83. Some applications of the dividend discount model could be complex. For example, in its DDM application, Bloomberg employed a threestage approach: growth years (assumed to be three to nine years), transition years (assumed to be eight to 14 years) and maturity years (beyond 17 years}. Average firms were assumed to have seven years of growth followed by 10 years of transition and then a steady state of maturity years (in perpetuity). High growth (slow growth) firms had shorter (longer) growth years and longer (shorter) transition years. Bloomberg examined current earnings and dividends to determine a payout ratio (dividends per share divided by earnings per share). Consensus earnings forecasts were employed to estimate growth year earnings increases. The current payout ratio was assumed to be steady during the growth years and then to typically increase during the transition years to a ratio of 45 percent at maturity. During transition years, earnings growth steadily declined to a longterrn \"sustainable\" growth rate at maturity: estimated as a return on equity (or investor's required return} times the earnings retention rate (or one minus the dividend payout rate). An example of the process is presented in Exhibit 4. Martin assumed the following for WalMart, which she categorized as an \"average\" growth type: growth of earnings of 13.7 percent during the growth period; 45 percent payout at maturity; the recently completed but not yet announced 2005 (i.e. calendar year) EPS was estimated to be $2.63 and the 2005 dividend paid was $0.58 per share; 2006 and 2007 EPS were estimated as $3.00 and $3.40, respectively; and the 2006 dividend per share was estimated to be $0.64. However, to simplify the daunting task of estimating all future dividends, a growth trend of the dividends could be used in a much simpler version of the model known as the constant growth dividend discount model. The constant growth DDM stated that the current value of a rm's stock price was equal to next year's (expected) dividend divided by the investor's required rate of return minus the expected dividend growth rate. Conversely, by rearranging the model, the required return could be decomposed into two parts: the expected dividend yield (i.e. the dividends over the next four quarters divided by the current stock price) plus the expected future growth in dividends. In other words, the required return could be thought of as a dividend portion as well as a growth portion that would be reflected in future capital gains. A modified version of this model replaced anticipated dividends with anticipated earnings times the anticipated dividend payout ratio. Anticipated dividend growth was often estimated in a variety of ways. First, historical dividend growth information could be measured and assumed to continue in the future. Second, future dividend growth could be estimated directly. The consensus annual WalMart dividend for 2006 was anticipated to be $0.64, and one estimate of the expected constant dividend growth (in perpetuity) was around 7.5 percent. Exhibit 5 presents historical dividend and earnings information on WalMart. CAPITAL ASSET PRICING MODEL In order to determine an appropriate discount rate for WalMart, Martin considered using the Capital Asset Pricing Model (CAPM), one of the more popular methods for estimating an equity investor's required (or expected) return. The model stipulated that equity investors required a return on what could be earned on riskfree investments, such as government bonds, plus a risk \"premium.\" The current longterm (10year) government bond yield was 4.40 percent. The general market risk premium for holding a diversied portfolio of equities was the difference between the expected return on the market (commonly considered to be the S&P 500 index) minus longterm government bond retums. 1WalMart's risk premium could be calculated as the product of the firm's risk relative to the market (known as beta) times the market risk premlum. By definition, the market had a beta of 1.0; less risky stocks had betas less than 1.0; and more risky stocks had betas of greater than 1.0. For example, if a stock had a beta of 1.2, this implied that if the market increased (or decreased) by 1.0 percent, the stock could be expected to increase (or decrease) by 1.2 percent. Information related to the estimation of 1WalMar't's beta is presented in Exhibit 6 and shows Bloomberg's beta estimate of 0.84.2 Studies had attempted to estimate the historical market premium, or the difference between returns on the equity market and longterm government bonds. From information I'1|"'JI'I"J'J +n 52:1 7."'Jn'1'2 .mn nnIIr lm nlinlm mJwnyn iv'r :InI-w-rn '2'1'19 ni \"In. .ni Dmml I Inilrnv-i'hr A. d-Imwi-unrl -'v-w provided by Bloomberg, Martin noted that the historical U.S. market risk premium was estimated to be 5.05 percent. PRICEIEARNINGS M U LTIPLE APPROACH PriceIeamings multiples were widely used in the investment industry because they were commonly available and easily used for comparative purposes. The intrinsic value of the stock was often estimated as the projected (upcoming year) earnings per share times an appropriate forward-looking PIE multiple (as determined by an analyst). In general, firms with better growth prospects andIor lower risk commanded higher multiples. Multiples varied through time and across industries. Forwardlooking multiples often differed from multiples based on trailing earnings depending on an analyst's assessment of future prospects; however, trailing multiples oen provided estimates of forwardlooking multiples. 1WalMart currently traded at a PIE ratio of 19.3 times (based on trailing earnings}. Exhibit \"I presents some comparable retail industry PIE multiples, WalMart's historical PIE multiples and historical PIE multiples for the S&P 500. Over a long history, U.S. market multiples averaged around 15 times. Martin wondered whether the PIE multiple approach could be of any help in determining WalMart's current value or anticipated future price. She would need to assess both growth prospects and risk in order to determine an appropriate forwardlooking multiple. Analysts were expecting WalMart growth to come primarily from two sources. One was an increase in Supercenters which were projected to grow from about 60 percent of WalMart's selling space to three quarters. It was thought that such a move might allow WalMart to increase its market share relative to supermarkets and department stores. Another growth source was its international divisions, which were expected to grow organically {i.e. through intemal growth} as well as through acquisitions. It was anticipated that international divisions would account for over onequarter of 1WalMart's sales within five years. As mentioned earlier, analysts were anticipating strong annual earnings growth of around 13.1r percent over the next ve years. While this was a strong growth rate, it was slightly below the annual growth in earnings of around 15 percent over the past five years. By comparison, industry growth over the past five years was around eight percent but was projected to be 14.6 percent over the next five years. The estimated industry PIE multiple based on projected 2006 earnings was around 22.6 times. S&P 500 earnings growth over the past ve years was around six percent and was also projected to be 5.9 percent over the next ve years. The estimated S&P 500 PIE multiple based on projected 2006 earnings was around 16.8 times. In terms of assessing risk, Martin reviewed WalMart's IOK ling, an annual report and disclosure document led through the Securities and Exchange Commission. As part of the documentation, which included WalMart's nancial statements, WalMart performed a selfassessment of the risk factors it faced that \"could materially and adversely affect our business, nancial condition and results of operations." These risks included: general economic conditions, impediments to expansion both domestically (including conversion of discount stores to Supercenters} and internationally, failure to attract and retain employees and related labor issues, strong competition, vendor risk1 legislation risk, and current legal proceedings (some involving federal and state wage laws}. VALUING WAL-MART'S STOCK Martin had all the information she needed to value WalMart's stock. She wondered whether the price she was about to calculate would match the current price. If it was higher or lower, would it imply that the stock was a good buy or not, or would she need to reconsider the assumptions and model inputs? For simplicity, she would begin by using annual data and projected dividends and earnings for 2006. Exhibit 1(a) WAL-MART CONSOLIDATED STATEMENTS OF INCOME (for Fiscal years ended January 31) (all amounts in $ millions except per share data) 2004 2005 Revenues Net sales 256,329 285,222 Other income -- net 2,352 2,787 Total revenues 258,681 287,989 Cost of goods sold 198,747 219,793 Gross prot 59,934 68,196 Expenses Operating, selling, and general and administrative expenses 44,909 51,105 Interest expenses -- net 832 986 Total expenses 45,741 52,091 Earnings (income) before taxes and minority interest 14,193 16,105 Income tax 5,118 5,589 Earnings (income) before minority interest 9,075 10,516 Minority interest {214) {249) Earnings from discontinued operations (net of tax) 193 - Earnings after tax (net income) 9,054 10,267 Average number of shares outstanding (millions) 4,383 4,259 Netincome pershare $ 2.08 $ 2.41 Exhibit 10)] WAL-MART CONSOLIDATED BALANCE SHEETS (as of January 31] {all amounts in $ millions) ASSETS Current assets: Cash and cash equivalents Accounts receivable Inventories Prepaid expenses and other Total current assets Property, plant and equipment {PPE}: Land (property) Plant and equipment (PE) Less: accumulated depreciation Net PPE Goodwill Other assets Total assets LIABILITIES AN D EQUITY Current liabilities: Commercial paper Accounts payable Accrued liabilities and income tax Current maturities of long-term debt Total current liabilities Long-temi debt Deferred income taxes Minority interest Shareholders' equity Total liabilities and equity 2004 5.199 1.254 28,612 1,358 34,421 12,699 82,008 15,684 59,023 9,882 2,079 105,405 3,267 19,425 12,048 3,100 37,840 20,099 2,359 1.484 43,623 105,405 2005 5,488 1,715 29,447 1,841 38,491 14,472 72,732 18,637 88,587 10,803 2,382 120,223 3,812 21,671 13,438 3,989 42,888 23,669 2,947 1,323 49,398 120,223 Exhibit 1(c) WAL-MART CONSOLIDATED STATEMENTS OF CASH FLOW {for fiscal years ended January 31) {all amounts in $ millions} 2004 2005 Operating activities Net income (continuing operations) 8,861 10,267 Depreciation and amortization 3,852 4,405 Deferred taxes 177 263 Net change in operating assets and liabilities 2,883 {269) Other (net) 223 378 Net cash provided by operating activities 15,996 15,044 Investing activities Purchases of property, plant and equipment {PPE) {10,308} (12,893) Investment in international operations (38) {315) Proceeds from sales and disposals 1,981 953 Other investing activities 53 {96] Net cash used in investing activities {8,312} (12,351) Financing activities Issuance of debt 4,787 6,376 Payments of debt (3,846) (2,335) Purchases of stock (5,046) (4,549) Dividends {1,569} (2,214) Other financing activities 111 113 Net cash used in nancing activities {5,563} (2,609) Effect of exchange rate changes 320 205 Cash Net increase during year 2,441 289 Balance at beginning of year 2,758 5,199 Balance at end of year 5,199 5,488 \fExhibit 3 WAL-MART DIVIDEND SUMMARY 1995 lo 2005 1211312005 811612000 811912005 311712000 512012005 1211711999 311812005 911711999 1211712004 811811999 812012004 311 911 999 512112004 1211111998 311912004 911811998 1211912003 811911998 1 01812003 312011 998 612012003 121191199? 312112003 911911997 1212012002 812011 99? 912012002 311 911 99? 612112002 1211311998 312212002 91311 998 1212112001 811711998 912112001 311911998 612212001 121111995 312312001 91511 995 1212212000 811211995 911512000 312111995 Adjusted for 2 for '1 stock 5pm on March 19, 1999. \f\f\f\f