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Is Whole Foods’ Stock Worth The Price?

Mark Hulbert, who won his fame by holding financial newsletters accountable for their performance, wrote an interesting piece on the stock prospects for Whole Foods. He noted an anomaly in that this rapidly growing, high P/E multiple stock is eschewed by most of the well known growth-oriented investor newsletters he monitors but is praised by several value-oriented newsletters.

The growth newsletter editors are scared off by the stock’s high price, but the value editors speak differently:

“…in a comment that is typical of many value-oriented advisors, Motley Fool Stock Advisor co-editor David Gardner had this to say when recommending the stock: “I take a very long view of my (recommended) companies. I don’t make “20% guesses” as to whether a stock’s next 20% move is up or down. I simply look for the best companies in America and plan to hold them for the long term. I don’t mind paying up now for a stock that I believe will continue to deliver big gains over the coming years.”

I know and respect Dave Gardner. He is a very smart guy, and he and his brother actually gave me a position during the early years of The Motley Fool as the “Media and Entertainment Stock Analyst”, and I wrote a chapter of a book for The Motley Fool that was never published — though they paid me in full. So he is a good guy in my book.

But I think he is mistaken on this matter. The problem is this: Whole Foods trades now with a trailing P/E, or price earnings ratio, of over 50. It does so because it is perceived as having enormous growth potential.

One risk, of course, is that it may not realize that growth. In this case it would be worth much less. This is a very real risk because as Whole Foods goes from a niche player to a major player, one can predict it will attract new competitors.

But even if it obtains its growth targets, as the company grows, its prospects are likely to become more limited. So P/E compression will likely occur. This means that the company could have double the earnings it does now, meaning it grew substantially, but the stock’s P/E ratio could drop in half to reflect the company’s slower growth prospects off this much larger base.

Wal-Mart, for example, currently trades at a P/E of around 18. Over the last five years, its average P/E was 24; over the last ten years, its P/E was almost 30. As the company has grown, it is harder and harder to maintain rapid growth, and the stock market awards a lower P/E ratio.

Warren Buffet, the famous investor, enjoys saying that in the short term the stock market is a voting machine but in the long term it is a weighing machine — which means that in the short term, the stock of Whole Foods may go up or down depending on opinion, but in the long run, its results would have to be not merely exceptional but super-duper extraordinarily exceptional to justify its P/E of over 50.

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