Brian DurnoDoes a great company make for a great stock?

By Brian Durno, CFA

The Walmart Story

The year was the 1999.  Lance Armstrong won his first Tour de France that summer, the Euro was first introduced to financial markets, and the Dow Jones Industrial Average closed above 10,000 for the first time in its history (March 29th, 1999).  Walmart entered the US grocery business in 1987 and by 1999 was on the verge of becoming the largest grocer in the US (they achieved this in 2002).  From 1991-1999, Walmart grew its earnings from $1.3 billion to $4.4 billion.  It was no secret that Walmart was having success not just in the grocery business but overall – it boasted a return on its equity of over 22% (a very high level of profitability).  You will also remember the high-tech bubble during this period.  One thing that is often overlooked in this period is that it wasn’t just technology stocks that got caught up in the bubble, it was also stalwarts like Walmart and Coca-Cola (to name just a few).

If I were to tell you back in 1999 that Walmart, one of the world’s top retailers, was about to achieve dominance in the lucrative US grocery business while strengthening its global leadership position in general merchandise, would you think the stock should do well in the years to come?  What if I had a crystal ball back in 1999 and told you that that over the next 10 years, earnings would more than triple, from $4.4 billion to almost $14 billion which they did (keep in mind that $14 billion is about 1% of Canada’s GDP).  Would you be lining up to buy shares?  Well, you wouldn’t be alone. Tens of millions of shares traded back in 1999 when Walmast first closed above $52.00 per share, $52.57 to be precise, on October 22, 1999. Today, more than 10 years later, on November 9th 2009, Walmat closed at $52.00…again.  You did have the benefit of receiving a growing stream of dividends while you waited ($0.16 dividend per share in 1999 grew to $1.09 today) but the performance of this stock was awful.  What went wrong?

While Walmart's logo got friendlier - buying the stock 10 years ago wasn't such a good idea.

The business results were nothing short of spectacular.  However, what went wrong was the price you paid in 1999 was too high…far too high.  Let me demonstrate how expensive Walmart was back in 1999.  In the example, I will assume no inflation or taxes.  If I were to offer you $1 per year every year for 10 years, what would that be worth to you?  You will receive $10 in total so if you wish to simply break even, you would pay me $10 for this arrangement.  In investment terms, we would say that the price you are paying is 10x earnings (ie $10 upfront now for a promise of $1 per year for 10 years).  This is also known as the price earnings ratio (or PE ratio, in this case 10x).  10 years is a long time to wait to break even so you may think about my offer and decide to keep your $10. In 1999, Walmart’s earnings amounted to about $1.00 per share. That means that when Walmart first traded at a share price of $52.00 in 1999, investors were paying 52x earnings. If you were thinking that 10 years to break even in my offer was a long time to wait, then with Walmart’s valuation, waiting 52 years to break even must seem absurd. That is, unless you believed that Walmart would grow their earnings every year so that the money you receive each year increases so that your purchase price of $52.00 seems like no big deal.

Clearly, it is very important to be able to solve for the growth rate that would make this trade of $52.00 today for $1.00 in income to make financial sense. Ignoring inflation and taxes, with no growth it will take 52 years to get your money back.  Without going into the details of our calculations, we use a model that can translate a price earnings ratio into an implied growth rate that is embedded in the valuation of any financial arrangement. This allows us to compare the market’s expected growth rate based on today’s prices being offered with our estimated growth rate in earnings of a particular business.  Framed this way, it is much easier to see the absurdity of high valuations.  Back to our Walmart example. Remember, its PE ratio was 52x the $1.00 in earnings, so clearly the market was expecting some growth in Walmart’s earnings over time.  Based on our model, Walmart’s implied growth rate back in 1999 was almost 25% per year for 10 years before leveling off to 4% growth from that point on.  That would imply earnings of almost $40 billion by 2009 (actual earnings in 2009 were almost $14 billion). Historically, only about 10%-15% of companies have been able to grow earnings by more than 10% per year over a long period of time.  Framed in this context, it is clear that $52.00 for Walmart stock back in 1999 was not a reasonable price.  You may be interested to know that $52.00 wasn’t even the peak for Walmart stock. Walmart traded at $64.72 on December 31st, 1999.  Remember, it closed at $52.00 on November 9th, 2009.

Although there was no permanent destruction of capital in this example, you can see that your capital would not have been earning a reasonable return by holding this stock for 10 years. That brings us to the most important lesson from this discussion which is the importance of separating the performance of the business from the performance of the stock. It is easy to see that Walmart has had an incredible decade of business success. However, by seriously overpaying back in 1999, long term buy and hold investors have not been rewarded for their decision. It can take many years for excesses in valuation to be cleansed from the system. In our example, the price that investors are paying for Walmart’s earnings has fallen from 52x back in 1999 to just under 15x today.  Walmart is not unique in its experience over the last 10 years.

It takes more than finding a great company to make money in the stock market.  It also takes paying the right price. Any discussion about a company without reference to its valuation is incomplete.  To paraphrase Warren Buffett, ‘all investing is laying out money now to get more money back in the future’. Paying careful attention to how much you are laying out now relative to what you will be getting back can prevent many mistakes.