Whole Foods Market, Inc. (WFM), The Kroger Co. (KR), Safeway Inc. (SWY): Why Earnings Quality Matters

Kroger’s superior return on equity is due entirely to financial leverage. If each company operated with the same level of debt, Whole Foods would have a much higher return on equity than either of the other two companies because it scores higher on the business-related metrics: margin and turnover. Its business is in better shape than its competitors, but its capital structure is less aggressive.

Kroger has steady earnings and decent growth prospects, which enables it to carry a higher debt load than companies that have less certain futures. Safeway, too, is in a better position than most companies to shoulder a few billion in debt. But neither is nearly as profitable as Whole Foods.

It may be tempting to hitch your wagon to a high return on equity company like Kroger, but consider that you could “manufacture” the same leverage by buying Whole Foods on margin or leveraging with long-dated call options. In this sense, you the stockholder can increase Whole Foods’ leverage even though the company is unwilling.

Bottom line

Simply looking at a company’s bottom line is not good enough. Investors need to dig into a company’s financial statements to figure out the true sources of earnings. Kroger and Safeway distort returns via leverage, while Whole Foods derives high-quality earnings from its operations. All else equal, long-term investors may want to consider a high-quality company like Whole Foods.

The article Why Earnings Quality Matters originally appeared on Fool.com and is written by Ted Cooper.

Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Whole Foods Market. The Motley Fool owns shares of Whole Foods Market.

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