Wesfarmers and Woolworths: Buy, hold or sell?

For many investors both Wesfarmers (ASX: WES) and Woolworths (ASX: WOW) are cornerstone investments in their portfolio. This is understandable given the high quality nature of both businesses and the relatively stable and dependable earnings and dividends that both companies produce.

For investors who already own these blue chips, it is likely the stocks would need to be significantly overvalued before they would consider selling their holding given the high quality, blue chip nature of each company.

For investors who are considering adding Wesfarmers or Woolworths to their portfolio the proposition is different. First, they need to determine the value of each company and then second, they need to decide how large (or small) a margin of safety they require between price and value before they purchase.

According to CommSec, the consensus forecast of analysts is for Wesfarmers to grow its earnings per share (EPS) by 14.9% in the financial year ending 30 June 2014 to 224.7 cents per share. With the shares currently trading at $42, this implies a price-to-earnings ratio of 18.7 times. Meanwhile, the analyst consensus forecast for dividends in FY 2014 is 200 cps, which implies Wesfarmers is trading on a forecast dividend yield of 4.8%

In comparison, analyst consensus (again according to CommSec) is for Woolworths to grow EPS by 4% to 196.2 cps for FY 2014. With the shares currently trading at $34.50 this implies a PE ratio of 17.6 times. The analyst consensus forecast for dividends to be paid in FY 2014 is 140 cps, which corresponds to a forecast dividend yield of 4%.

For benchmarking purpose, the S&P/ASX 300 Index (Index: ^AXKO) (ASX: XKO) is currently trading on a forecast PE ratio of 17.8 times and a forecast dividend yield of 4.25%.

Foolish takeaway

Based on the above relative valuations, neither stock appears significantly overvalued. That suggests a ‘sell’ can be ruled out at current prices. Shareholders in either company are likely comfortable to continuing to hold the stocks at current prices. The real issue is whether either Wesfarmers or Woolworths are currently priced to buy.

Warren Buffett has generally looked for a 30% margin of safety to intrinsic value, although he has also said he will ‘pay up for quality.’ Wesfarmers and Woolworths are both quality stocks, but exactly what multiple of earnings and what discount to intrinsic value an investor thinks is reasonable is up to the individual investor to decide.

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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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