Domino's Pizza Enterprises Ltd. & Retail Food Group Limited: 2 stocks I won't buy today

Domino's Pizza Enterprises Ltd. (ASX:DMP) and Retail Food Group Limited (ASX:RFG) are not good value at today's prices.

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Domino's Pizza Enterprises Ltd. (ASX: DMP) and Retail Food Group Limited (ASX: RFG) have been star performers over the past five years, rising 599% and 174% respectively. Both are food retailers and have strong brands, scalable franchise models and international exposure. They have also paid dividends in each of the past five years, so what's not to like?

The importance of return on equity

Although many people use profit growth or earnings per share (EPS) growth, return on equity (ROE) is the key investment measure for determining the quality of a company.

The reason that profit is inadequate is that it takes no account of new shares being issued. For example, suppose you own $10 of shares in a company that makes $1 million profit and has a market capitalisation of $10 million. It then announces an exciting acquisition with $0.5 million of profits, costing $20 million and paid for by issuing new shares. Before the acquisition, your share of the company's profits was $1, but now it has been diluted to 50 cents. Nonetheless, the company will report profit growth of 50% from $1 million to $1.5 million in its next set of results.

EPS is better than profit because it takes into account the number of shares on issue and therefore is not vulnerable to the type of situation above. However, it is still not perfect because it does not adjust for profits that are retained in the business.

Suppose two companies, A and B, grow their earnings per share by 1% per year but A pays out 100% of its profits as dividends whilst B pays nothing. Clearly, A is the better business but on an EPS basis they look the same.

Furthermore, B is actually a poor company despite growing EPS at a modest rate. This is because if you put your money in a savings account it would perform better than B, since it would deliver EPS growth of around 3.5% in the form of compound interest with no risk.

Measuring ROE over time gives a true indication of business performance as it measures profit in relation to total equity, both that which is externally raised and that generated internally from profits retained in the business.

Why I wouldn't buy Retail Food Group

Over the past five years Retail Food Group has not performed particularly well in terms of ROE. Equity has increased by more than $200 million whilst profits have risen by $13.3 million giving ROE of 6.6% on the additional funds used by the company over the period.

Although 6.6% is by no means terrible, it is low for a business with such a capital light model and historically, Retail Food Group has managed to achieve ROE of more than 20%. Despite this, the company trades on a prospective enterprise value to free cash flow multiple (EV/FCF) of well over 20 and so it seems the market is expecting significant improvement going forward.

Why I wouldn't buy Domino's

Domino's, on the other hand, is an exceptionally run business and has managed to improve its return on equity over recent years whilst growing quickly. It is simpler than Retail Food Group because it operates just one brand and successfully uses technology to constantly refine its offering.

My problem with Domino's is that it is one of the most expensive businesses on the exchange with a forward EV/FCF of nearly 60! I created a discounted cash flow model to understand what future cash flows would be required for the business to be worth its current price.

Based on a skimpy discount rate of 5% (chosen to reflect current interest rates which may not be sustainable), Domino's would have to grow its profits by 10% per year for 20 years and then maintain its twentieth year profits forever in order to justify current prices. To put that in context, it assumes that in twenty years' time, Domino's will be making profits of over $400 million compared to $60 million today.

Motley Fool contributor Matt Brazier has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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