Are these great companies still cheap?
Using DCF model and Peter Lynch chart we analysized the valuation of Wal-Mart and ADP.
In November of 2010, renowned deep value investor Arnold van den Berg wrote a great piece called How do great companies get so cheap (see GuruFocus)? He pointed out that the stocks of the great companies like Wal-Mart (WMT) and ADP (ADP) were on sale. He argued that the four emotions that investors went through when owning the stocks made them cheap: apathy, disgust, fear and anger. At the time of the writing, WMT traded at $54 and ADP at $43. Since then, their stock prices had gained 44% and 63%, respectively.
The question we would like to ask now is: are these stocks still cheap?
To see if these stocks are cheap, we would like to check their valuations using three methods: Discounted cash flow (DCF) calculation, reverse DCF calculation, and Peter Lynch chart. Since these companies have quite stable and predictable business, DCF and reverse DCF will work pretty well.
Wal-Mart (WMT)Wal-Mart has been growing its revenue by about 3.5% a year over the past five years. Its earnings grew faster, at about 5% a year, due to margin expansions. Coupled with about 4% a year of share buybacks, this giant company has been growing its earnings per share at the rate of 10% a year.
Considering Wal-Mart has a very stable business, we may ask for lower discount rate in DCF and reverse DCF Calculation. At a 10% discount rate, Wal-Mart is worth about $88 a share, which gives a margin of safety of 15% at the current market price. Please see the screenshot of the DCF Calculator below:
If we switch the DCF calculator to reverse DCF mode, we get a growth rate of 7.8% as shown below:
Over the past 10-year and five-year periods, Wal-Mart has grown its revenue and earnings per share slightly faster than that. Based on the calculation, we can confidently see that Wal-Mart is probably slightly undervalued or fair valued.
This is further confirmed by the Peter Lynch chart of Wal-Mart below:
Historically, Wal-Mart was traded at much higher valuations. Please see the historical price-to-earnings ratio chart below:
Currently, Wal-Mart is traded at a price-to-earnings ratio of 15.1. The lowest point was below 12 at about two years ago.
ADP is the slower growing than Wal-Mart. The historical low interest rate hurt its growth and margins. The company grew its revenue at about 5% a year over the past five-years, while its margin shrank and its profit declined. Even with share buyback, the company only grew its earnings at about 3% a year. Assuming 6% growth, 10% discount rate for DCF Calculation, the stock still appears to be overvalued. This is also confirmed by the Peter Lynch Chart:
Historically, ADP has been traded at a higher price-to-earnings ratio. The historical median price-to-earnings ratio is 23.6, which is exactly where it was traded at. ADP price and its earnings line of historical median price-to-earnings ratio of 23 is shown below:
Therefore, ADP stock is probably somewhere between fair-valued to overvalued.
With the recent stock market run up, many large-cap stocks that were out of favor are not undervalued any more. Among the two companies discussed here, none is clearly undervalued. If one has to invest in one of them, Wal-Mart would be the best choice, although most likely it will not deliver as large gains in the coming years as it did in the last two years.
As suggested by GuruFocus market valuation page, the U.S. market is overvalued, and it is positioned by the annual gain of 2%-3% a year in the coming years. We do not know where the stock market will go, but as value investors, the bottom up approach clearly indicates that bargains are much harder to come by these days.
We believe that our DCF/reverse-DCF calculator and Peter Lynch chart can help you realize this, too.
Copyright © 2014 Microsoft. All rights reserved.
As geopolitical tensions threaten to spin out of control, investors are wondering how best to position their portfolios for the global turmoil.
VIDEO ON MSN MONEY
Top Stocks provides analysis about the most noteworthy stocks in the market each day, combining some of the best content from around the MSN Money site and the rest of the Web.
Contributors include professional investors and journalists affiliated with MSN Money.
Follow us on Twitter @topstocksmsn.