1. First you have to know where the money is going.
- Is WMT expanding in Mexico or is WMT expanding somewhere in Europe where it has no competitive advantages.
- You can look at the simple economics with and without infrastructure costs and you see the returns if they have to build the infrastructure are about 7% to 8% which is below their cost of capital (Kcost).
- If they can add stores to an existing infrastructure (stores near existing supply depots and other WMT stores), then the returns are more like 17% to 20%.
- But you ought to know enough about the economics of growth stocks, so you know those numbers.
- If the return is 20% after tax and their cost is 10%, what each dollar they reinvest worth? $2 because they are earning 2x the cost of capital.
- So what you are going to do is take that reinvestment return—that 5% that is reinvested and multiply it by the difference between the capital return and cost of capital.
- If they are earning 7% and Kcost is 10%, they are destroying at the rate of 3%.
- A crappy return.
- The longer they hold that cash the lower the return is in terms of reinvestment.
- You are losing the return on that cash.
- When WMT sees an increase in SSS, it typically doesn’t have to build any new stores.
- Especially if it is a price increase, its doesn’t have to add new people or add SKUs.
- What is the capital investment required for that increase in sales? Only inventory.
- If their inventory turns are 8 times, then for every $1 of sales, they make about 7.5 cents in profit.
- That organic growth generates returns of about 16%.
- They are higher than that in reinvestment because typically they will refinance two-thirds of the inventory investment with debt.
- So you will be getting returns of 150% on the capital you invest to support that organic growth.
Verify the existence of a franchise
Notes from video lecture by Prof Bruce Greenwald