Is Woolworths getting too expensive?

World famous investor and billionaire Warren Buffett has always credited much of his success to his mentor Benjamin Graham. One of the most important investment tenants Graham instilled in Buffett was the concept of a margin of safety.

The margin of safety concept suggested to investors that after a careful study of a company and a conservative valuation based primarily on past facts rather than forecasts, a company could be considered for purchase if it was selling for at least 30% less than the valuation.

As time has passed, Buffett has made adjustments to that 30% rule. For example when he purchased The Coca-Cola Company (NYSE: KO), the margin of safety was based more on Coke’s incredible brand power and future potential earnings rather than a strict adherence to Graham’s original margin of safety rule.

With the margin of safety concept in mind, it is interesting to ponder the safety in purchasing Woolworths (ASX: WOW) stock at current levels. The stock currently trades on a forward (financial year 2014 Morningstar estimates) price-to-earnings ratio of 16.25 and a yield of 4.25%.

There are many attributes to like about Woolworths business. It is a market leader with a highly stable entrenched market share and its balance sheet has a ratio of 27% net debt to equity (not including off-balance sheet liabilities) which looks solid considering the predictable, maintainable earnings.

This large and powerful position also has its drawbacks though, namely a lack of high growth potential. It is hard to see Woolworths being anything other than a slow growing giant. Its size and power means it is always under the watchful gaze of the Australian Competition and Consumer Commission (ACCC). Making meaningful moves into new earnings streams requires large investments and potentially large risks — as an example management’s decision to take on the Wesfarmers’ (ASX: WES) owned Bunnings hardware chain has so far cost many millions of dollars with no guarantees of success.

While some investors choose to focus on high growth stocks, other investors are quite happy to own established slow growers. One of the advantages of a company which has gone ‘ex-growth’ is the potential for the business to be a ‘cash cow’. With growth not a viable option, the company can instead return all excess cash to shareholders. Woolworths has a payout ratio around 70% which is high but not quite at ‘cash cow’ levels.

Foolish takeaway

There is nothing wrong with buying companies that may only grow slowly; as always it comes back to the price you pay. At current prices, Woolworths’ could potentially be considered fully priced. With a forward earnings multiple of over 16 times, investors purchasing stock at these levels are presumably expecting a reasonably high growth rate from the company — this may or may not prove to be an accurate expectation. Investors looking to purchase any stock including Woolworths should always asking themselves if they are leaving a margin of safety in case they are wrong.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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