Is Wesfarmers Ltd overpriced?

It’s important to consider downside risks and not just upside potential.

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While much of the value investing world’s attention over the weekend has been on the events in Omaha, Nebraska, as billionaire investor Warren Buffett presided over the Berkshire Hathaway Inc. (NYSE: BRK.A) annual general meeting, there are of course a number of other important investors associated with Buffett that are worthy of attention.

One of those is the man who sits alongside Buffett on stage – Charlie Munger.  Munger has long been credited with influencing Buffett towards making some of Berkshire’s key acquisitions including its stake in The Coca-Cola Company (NYSE: KO). It’s also worth noting who Munger has entrusted some of his personal wealth to – fund manager Li Lu.

It’s easy to see why Munger views Lu so highly, not only is there a superb track record of investment success, but Lu is also credited with making statements such as this: “Being a value investor means you look at the downside before looking at the upside.”

Having watched Lu give presentations in the past, it quickly becomes apparent how much he lives and breathes the above statement. Unfortunately it’s a concept which many investors struggle to grasp. The noise of the market and the desire to get rich quickly leads many investors to focus on upside potential and disregard downside risk.

While there is no denying the quality of some of Wesfarmers Ltd (ASX: WES) assets, Lu’s instructive quote is worth consider for a company trading on a multiple of 22 times historic earnings. The strong organic growth being achieved at Bunnings and the rejuvenation of the Coles business should see earnings per share grow as 5.2% and 13.4% over financial years (FY) 2014 and 2015 (according to Morningstar’s consensus data).  If Wesfarmers achieves these solid growth rates then the stock would be trading on a FY 2015 price-to-earnings multiple of 18.4.

The question for investors is whether these multiples represent a reasonable valuation for the company given the implied growth rates and importantly whether this valuation accounts for the potential downside risks to consensus forecasts?

Foolish takeaway

Of course plenty of companies deserve to trade on high multiples, just as many firms deserve to trade on low multiples – the point is that ascribing a multiple to a stock involves considering the quality of the business, its opportunities to reinvest its capital at high rates of return and its growth outlook.

Even for companies expected to grow at extremely high rates, such as REA Group Limited (ASX: REA) and Domino’s Pizza Enterprises Ltd. (ASX: DMP), there is still a limit as to what a reasonable multiple is to ascribe to these high growth business.

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

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