Whole Foods (NYSE:WFM) shares have performed incredibly well since collapsing during the financial crisis in 2008. Since bottoming, it is up 10-times in value, and there are seemingly good reasons for this. Whole Foods has grown its sales and profits substantially while successfully defining itself as the gold-standard among luxury grocery stores. Whole Foods customers are loyal and they have disposable income, and this is more than can be said about virtually any other grocery chain — but this doesn’t necessarily make Whole Foods a good investment.
First, while Whole Foods has a loyal customer base, the fact remains that the grocery business is cutthroat. Grocery stores are everywhere, all competing for your business. Furthermore, groceries can be purchased at a wide variety of locations from convenience stores to gas stations to restaurants to drug stores. Thus, no matter how loyal Whole Foods’ customer base is, its customers are buying a great deal of their groceries at other locations.
As a result of this competition, margins for Whole Foods and its competitors are razor thin, and this is in spite of the fact that Whole Foods has relatively high prices. In the most recent quarter, Whole Foods had a net profit margin of just 3.73 percent, and this is down from 4.27 percent a year earlier. As a result, while the company grew its net sales by 10 percent, it grew its profits by just 8 percent.
Now, this is extremely strong for the grocery business, and such a performance is highly commendable. However, Whole Foods stock trades at 34-times trailing earnings, and at 32-times next year’s estimated earnings. This is incredibly expensive given the nature of the grocery business and given that the stock market trades at 23 times earnings, which is expensive enough as it is. Even if we assume that the business should trade in-line with the already over-priced S&P 500, Whole Foods stock should trade at more than a 25 percent discount to its current price. Furthermore, with an 8 percent earnings growth rate, one could argue that the stock shouldn’t trade at a P/E ratio more than twice that, meaning that the stock shouldn’t trade at more than 16-times earnings. This means the shares have 50 percent downside.
If we consider other valuation metrics such as dividend yield (0.94 percent) and price to book value (4.8 times) it becomes evident that investors are ascribing a lot of value to Whole Foods as the leader in its industry. As a prudent investor, I find it very difficult to pay such a high premium for any stock in any industry without very good reason to do so. Given the cutthroat nature of the grocery business, I am especially skeptical of Whole Foods’ valuation.
With that being said, if there is one stock worth owning in this industry, it is probably Whole Foods. Investors looking to take a position in the stock should consider waiting for a lower valuation. Above, I suggest 24-times earnings and 16-times earnings may be points at which one can begin to justify owning shares in Whole Foods. But given that investors are relatively optimistic that Whole Foods will live up to its current valuation, we will likely not see these lower valuations without a dampening in expectations. This means that, as with every good investment, deciding the right time to buy the stock probably won’t come until investors become pessimistic and anticipate a continuation of deteriorating margins or a weak consumer. However, I suspect that those investors who wait for this sentiment to develop will be happy that they did.