Act Now Before Walmart’s Undervalued Shares Take Off

During the past decade, analysts have collectively raised and lowered their rating on Walmart (NYSE: WMT) hundreds of times. Perhaps they shouldn’t have bothered. The stock has gone nowhere in 10 years, having been mostly stuck between $45 and $60 for all of that time. But just because the stock hasn’t gone anywhere doesn’t mean investors can’t make money from it. Some have profited handsomely by knowing when to repeatedly enter and exit the stock. It’s a simple approach, though it involves a bit of math, which I’ll detail in a moment.

A different kind of growth stock
Walmart has still been a nice growth story during the past decade. Earnings per share (EPS) rose by at least +10% from through 2003 to 2006, cooled a bit from that level in the next few years, but rebounded to rise another +11% in fiscal 2010. Analysts think profits can grow about +10% this year and next year. Trouble is, Walmart began the past decade trading at 70 times trailing earnings. So as profits have grown, the P/E ratio has compressed and shares now trade for just 11 times next year’s projected earnings.

Could that P/E ratio expand? Perhaps by a little bit. The retailer appears to be on the mend, taking market share in the grocery aisle and in international markets. And as I concluded recently, “if the multiple finally starts to move up to 12 or 13, then investors are looking at +20% to +30% upside. After a decade of moving sideways, it may seem foolhardy to predict a big run for shares of Walmart at this point. But a combination of rising sales, improved sourcing, tighter expense control and a reduced share count make this mega-retailer poised to surprise on the upside.”

Walmart’s real yield

Indeed shares may move up, and you’ll need to effectively gauge when to take profits. You’ll find no better gauge than free cash flow, which is operating cash flow minus capital expenditures. Since Walmart is now as large and stable as any company you’ll find, look at that free cash flow as a sort of proxy for the company’s income-producing capabilities. This is known as the free cash flow yield. (In this instance, Walmart’s yield is not a useful gauge, as the mega-retailer offers a fairly low payout).

Walmart generated around $8 billion in free cash flow in fiscal 2009, $9.9 billion in fiscal 2010, and should see that metric rise to around $10.6 billion this fiscal year. The entire company is valued at $190 billion, which means that the free cash flow yield ($10.6 billion/$190 billion) is about 5.6%. That’s substantially higher than “A”-rated corporate bond rates, which yield 4.3%, according to Walmart is arguably more stable than most “A”-rated bond issuers and is more akin to an “AA” or even “AAA”-rated issuer.

Action to Take –> By this math, relative to corporate debt, Walmart’s equity is quite attractive. The shares would need to trade up to around $65 to be valued comparably. Investors can feel comfortable owning shares at current levels, but be prepared to sell if they move into the low $60s, making for a nice range-bound trade. The shares provide even more comfort at current levels when you consider that sales are modestly growing and per share profits are growing at an even faster pace, thanks to ongoing massive stock buybacks.