Is Woolworths a buy?

Earnings per share growth has slowed over past five years and the company is trading on a lofty P/E ratio of 19.2

Mike King

Mike King is a Fool.com.au Investment Analyst and Writer. He caught the investing bug more than a decade ago, at a time when the U.S. had invaded Iraq and fear reigned in the markets. His initial success as the markets took off encouraged his passion and thirst for knowledge. With 13 years behind him at one of Australia's largest domestic banks, Mike's passion for stocks led him to join a boutique funds management firm, where he stayed for four years. A seven-year stint in equity research at one of the largest investment banks in the world followed that, giving Mike a thirst to pursue his passion further. Mike holds a Diploma in Applied Finance and Investment and a Graduate Certificate in Financial Planning. His passion is to help retail investors invest better, and that passion was one of his primary reasons for joining The Motley Fool Australia in late 2011. Mike has written thousands of articles since joining, including for Fairfax Media, Yahoo!7, Ninemsn and has also appeared on ABC's The Business. You can see all of Mikes' holdings here

Published October 24, 2013 12:04 pm AEDT

Supermarket retailer Woolworths (ASX: WOW) is trading on a lofty P/E ratio of 19.2, despite consensus analysts' estimates of just 4% growth in earnings per share in financial year 2014, and 5.6% growth in 2015.

Still, that's below the company's long-term average P/E ratio of around 22 since 1998. In that time, revenues have grown from $17.3 billion to near $59 billion, and net profit from $280 million to $2.3 billion. And the company's share price has appreciated from an average of just $5.65 in 1998, to more than $34 currently. Shareholders invested since 1998 have seen a return of more than 1,000% on their investment, including dividends.

But the question is, how will the company be able to grow revenues and earnings in future?

Between Woolies, Coles – owned by Wesfarmers (ASX: WES) and the Metcash (ASX: MTS) backed IGA supermarkets, the Australian supermarket space is pretty much sown up. Future growth is likely to grow at around the same rate as the Australian economy. Woolworths has also expanded into hotels, liquor, petrol and most recently, hardware. The company's Masters hardware stores are still at an early stage of development, and will deliver some growth as the company heads to its target of 150 stores around Australia. There are 31 Masters stores currently open, but the division has yet to turn a profit, and is likely to drag on Woolworths' earnings for at least the next couple of years.

Of concern is that over the past five years, earnings per share growth has been 12%, 9%, 5.6%, 3% and 2%. Notice a trend there?

It's not surprising then that Woolworths was considering a bid for Hong Kong retailer ParknShop, in an effort to pump up the growth. That bid appears to have been abandoned for now, but Woolworths still has the issue of how to generate growth. With the Australian market virtually saturated with supermarkets, Woolworths is either forced to look at other Australian industries, or offshore.

And that may be why the company is keeping its ambitions of entering the pharmacy business alive, despite the government's pharmacy agreement that pharmacies must be owned by pharmacists. But the agreement expires in June 2015, and maybe Woolies is targeting entry into the pharmacy business at that time.

Foolish takeaway

At current prices, Woolworths looks expensive, and in the search for growth a foolish (lowercase 'f') diworsification can't be ruled out, adding an extra level of risk at this time. But don't write the company off just yet, after all it has produced outstanding results over the past 15 years.

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Motley Fool writer/analyst Mike King owns shares in Woolworths.

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