Over the past year, Coles Group Ltd (ASX: COL) shares haven't done so well, dropping 6.5%. While this is better than its rival Woolworths Group (ASX: WOW), which is down 15%, Coles shares have underperformed the S&P/ASX 200 Index (ASX: XJO), which is up 9.3% during the same period.
However, Coles shares have performed better over the longer term. The stock has risen 28.9% over the past five years, outperforming the ASX 200 Index by 12%.
Could Coles shares continue to outperform from here on?
Breaking down share price returns
Share returns are influenced by two main factors: earnings growth and valuation multiple growth.
When a company earns more money (earnings), it becomes more attractive to investors, which usually pushes its share price up. Additionally, if investors become more optimistic about the company's future, they may be willing to pay more for its shares, increasing the price further. In simple terms, higher earnings and positive investor sentiment lead to better share returns.
For example, the current share price of Coles at $17.1 can be split into:
- FY24 earnings per share (EPS) estimate of 81 cents multiplied by a price-to-earnings (P/E) ratio of 21x
- FY25 EPS estimate of 84 cents multiplied by a P/E ratio of 20x
These two factors are based on market expectations, which are constantly updated depending on actual business results from Coles.
How fast can Coles' earnings grow?
The earnings estimates by S&P Capital IQ appear to assume Coles' EPS will increase at a compound annual growth rate (CAGR) of 6.7% over the next three years, as follows:
- 81 cents in FY24, implying a 3.4% growth over the previous year
- 84 cents in FY25, implying a 4.9% growth over the previous year
- 95 cents in FY26, implying a 12.5% growth over the previous year
The FY26 growth estimate of 12.5% is doubtful to me, but the economy may improve by then.
Considering Coles has consistently boosted its same-store growth between 2.5% and 5.8% over the past three years, the market consensus of high single-digit growth seems reasonable.
This means if the market is willing to keep applying 20x PE, then the Coles share price may increase by 6% to 7% as its earnings grow.
Valuation multiples
The next question is whether the current valuation multiple is fair. While there could be many different ways to look at it, I would use a simple approach here.
A P/E ratio of 20x means investors are paying $100 for an expected annual profit of $5. In other words, this means an earnings yield of 5%. This is different from a dividend yield because not 100% of the company's earnings will be paid to shareholders.
Then, we can compare this to other alternatives. For example, would investors want a 5% earnings yield from Coles shares rather than putting their money in the bank earning lower interest rates? The answer may be yes, given the cash rate by the RBA is 4.25%.
Also, Coles is one of the two leading grocery chains in the country, providing investors with stable and predictable earnings outlook.
For these reasons, Coles' PE ratios have rarely traded below 20x over the past 5 years.
So I would say the current PE levels are reasonable.
Can Coles shares outperform the index?
The ASX 200 Index generated a total return of 7.6% over the last ten years, including a dividend yield of 4.7%.
As we reviewed earlier, we can estimate Coles shares could generate a total return of approximately 11% based on roughly 6% to 7% returns from its earnings growth and by adding its dividend yield of 3.9%.
Based on this simple exercise, I think there's a reasonably high chance that Coles shares could perform better than the ASX 200 Index.
