The bottom-up style of stock selection — that is, beginning the selection process by analyzing individual equities as opposed to starting with studies of industries and sectors, then singling out companies — poses a problem for investors who focus on fundamentals. When looking at sales and earnings growth, profitability, return on equity and the stock’s valuation, they need to put these figures in context.
Earning 20 percent on each dollar of sales might seem like a healthy profit, for example. But if the company’s competitors are earning 30 percent, they might wonder whether the company is doing as well as it should. Fundamental analysis of individual stocks should therefore include consideration of how a company is performing relative to its peers.
In this article we’ll compare the fundamentals of two companies, CVS Caremark (ticker: CVS) and Walgreen Company (WAG), and try to decide which one provides the better opportunity for investment. I chose CVS and Walgreens because they’re well-known (particularly among BetterInvesting’s membership) and offer a relatively easy comparison.
This isn’t always the case. Various financial information services detail a company’s competitors, but in my experience the peers selected often don’t reflect the true competitive landscape. They’re often chosen because they’ve been slotted into a specific industry classification without further analysis of the company’s market. Investors should check the company’s annual reports, or even call the investor relations department, for a truer picture of peers.
An Orderly Process
Before beginning a comparison, it might save time to see whether both companies are even worth studying. What we look for at BetterInvesting are sales and earnings growth rates that are above average for the company’s size; consistent growth of sales and earnings; and growing or stable profitability and return on equity. If a company passes these tests, we have some assurance that we’re looking at a well-managed company worth considering for investment. In this case, we’ll say that despite struggling along with everybody else in recent times, both CVS and Walgreens are worth our time to study.
Our comparison begins by checking the sales and earnings growth rates for both retail pharmacy companies. Before CVS acquired Caremark in 2007, CVS and WAG had similar sales growth rates. This makes a lot of sense; after all, when one company opens a store, the other often builds one across the street. The Caremark acquisition significantly boosted sales for CVS, however, and sales at CVS grew at almost 14 percent in over the past two years, compared with 8.5 percent at Walgreens. The graphs also indicate that Walgreens’ growth lines seem to be flattening.
As for future growth, both companies seem to have similar prospects overall. CVS and Walgreens face challenges in their industry, but sales and earnings growth of 9 percent-10 percent over the next five years seems plausible. (Note that analysts, who are typically optimistic in their forecasts, are expecting long-term earnings growth of 12 percent for CVS and 14 percent for Walgreens as of early July.)
Our two tests of management effectiveness — pretax profitability and ROE — provide differing results. CVS and Walgreens had quite similar profitability over the past five years, with WAG coming out slightly ahead and generally being more consistent over a 10-year span. CVS has had the upper hand over the past two years, however. Meanwhile, Walgreens has had better ROE over the past 10 years. CVS has seen its ROE profile change since the Caremark acquisition, with ROE dropping to below 10 percent in 2007-2009.
We also note that CVS has carried more debt relative to capital over the long term, with percentages exceeding 25 percent since 2006. Walgreens generally has had debt to under 10 percent over the past 10 years. But we aren’t too concerned about the debt load at CVS; it’s a healthy, well-run company with a strong balance sheet.
Studying Valuation
So far, so good. Although CVS has the upper hand regarding growth, given the recent economy and industry headwinds, both companies remain interesting candidates.
Now it’s time to study valuation. The BetterInvesting methodology favors growth companies, but not growth at any cost. A stock’s current price-earnings ratio and expectations of future P/Es are important elements when forecasting return potential.
Over the past five years, CVS has had an average high P/E of 20.4, compared with 25.3 for Walgreens. Unsurprisingly, these P/Es have also been trending downward. In 2009, the high P/Es were 14.9 for CVS and 17.2 for Walgreens. The low P/Es tell a similar story. And the current P/Es (based on the most recent four quarters’ EPS) are pretty close: 11.5 for CVS versus 13.1 for Walgreens.
It might not be prudent to expect Walgreens to trade at a high P/E of 25 in future years. In fact, we could reasonably expect P/Es to remain at lower levels over the next five years, especially if inflation takes hold. For the sake of this exercise, let’s forecast a high P/E of 17. The multiple of CVS would likely follow a similar fate, with a high P/E of 15 seeming reasonable. On the low side, let’s project a P/E of 9 for CVS and 10 for Walgreens.
Now we’re ready to begin considering the return potential. When we multiply the high P/E by the expected high EPS (which we determined by starting with the most recent EPS and compounding the predicted growth rate over the next five years, we come up with the high price. On the low side, a common option for growth companies is to multiply the expected low P/E by the expected low EPS (which, for a growth company, should be the most recent EPS).
We then have a spread between the low and high potential price and an idea of the risk versus the return. We like to see at least $3 of potential gain for every dollar of potential loss. We also hope the stock’s potential return is at least 15 percent annually.
In this case, based on our projections both stocks pass these tests. Our forecasts lead to what’s called the upside-downside ratio of 4.6 to 1 for Walgreens and 5.1 to 1 for CVS. The potential annual return is 16.7 percent annually for CVS and 16.9 percent for Walgreens. (Both companies pay a dividend, by the way, with the yield for Walgreens being higher than that for CVS.)
Decision Time
So which stock is the better investment? Based on our judgments, both seem to have similar prospects. They’re both very well-managed and have shown an ability to sustain growth and survive difficult times.
This is often the situation when you’re studying industry leaders. My preference in these cases is to focus on the potential growth and P/Es of the companies. The long-term EPS growth rate projections are similar (analysts expect a little higher rate for Walgreens). So we turn to the P/Es and see that CVS is trading at a lower P/E and is projected to have an average high P/E that’s lower than Walgreens.
Your judgments and final call might well be different. But unless my additional study of the companies — the stock studies I’ve detailed provide about 80 percent of what I need to know — tell me otherwise, CVS comes out a winner in this comparison by a nose.
About BetterInvesting
BetterInvesting is a national nonprofit organization that has been empowering individual investors since 1951. Founded in Detroit, the association (formerly known as National Association of Investors Corporation) was borne out of the conviction that anyone can become a successful long-term investor by following commonsense investing practices. BetterInvesting has helped more than 5 million people become better, more informed investors by providing webinars, in-person events, easy-to-use online tools for analyzing stocks and mutual funds, a monthly magazine and a community of volunteers and like-minded investors. For more information about BetterInvesting, visit its website at www.betterinvesting.org or call toll free (877) 275-6242.
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