If investing were as simple as looking at a price-to-earnings ratio, we would all make great investments. But too often investors are surprised when a company reports substantially lower profits than originally forecast. This is usually the result of evaluating an investment based on its earnings or cash flow instead of evaluating the quality of those earnings.
This article breaks down the quality of three grocery stores' earnings -- Whole Foods Market, Inc. (NASDAQ:WFM), The Kroger Co. (NYSE:KR), and Safeway Inc. (NYSE:SWY) -- so that investors can determine which company is most likely to retain and grow earnings and which may surprise with lower earnings in the future.
Profit at a grocery store depends on the interaction of three key variables: margin, inventory turnover, and leverage. Usually, a grocery store will focus on selling either high-margin products with low inventory turnover or low-margin products with high inventory turnover. However, stores that combine high margins with high turnover earn exceptional profits.
Whole Foods Market, Inc. (NASDAQ:WFM) has the highest gross margin, followed by Safeway Inc. (NYSE:SWY) and The Kroger Co. (NYSE:KR), respectively. But profit margins are only meaningful when combined with inventory turnover. If a grocery store sells product at a high margin but is unable to sell items quickly, it will generate a low return on equity. So a low-margin grocery store can be better than a high-margin store if it sells its inventory quickly enough to make up for the low margin.
However, in this exceptional case, Whole Foods Market, Inc. (NASDAQ:WFM) has a high gross margin and it sells its inventory more quickly than the other chains.
As a result, one might expect Whole Foods Market, Inc. (NASDAQ:WFM) to generate a much higher return on equity than The Kroger Co. (NYSE:KR) and Safeway Inc. (NYSE:SWY), but it does not. Instead, Kroger maintains a significant lead in return on equity, while Whole Foods is much closer to Safeway.
Quality of earnings
Some number crunchers believe if you know a company's return on equity and its price-to-book ratio, you can calculate an expected return for the stock.
1). The Kroger Co. (NYSE:KR) trades at 4.3 times book value and has earned a 17.5% return on equity over the last 10 years. If you divide return on equity into the price-to-book ratio, you get an expected return of 4.1%.
2). Whole Foods Market, Inc. (NASDAQ:WFM) trades at 5.4 times book and has earned a 12.36% return on equity over the last 10 years. The 12.36% divided by 5.4 equals 2.3% expected return.
3). Safeway Inc. (NYSE:SWY) trades at just two times book and has earned a near 9% return on equity over the last 10 years. This yields an expected return of 4.5%.
So, if each company averages the same return on equity over the next decade as it did over the last, then Safeway Inc. (NYSE:SWY) and The Kroger Co. (NYSE:KR) offer a much higher return than Whole Foods. However, that probably will not turn out to be true.