Is Walgreen Priced for Perfection?

Walgreen's share price has soared over the past year, but its earnings growth hasn't kept up. Here's why you might want to think twice before buying in at these levels.

Jun 10, 2014 at 6:00PM

Pharmacy operator Walgreen (NASDAQ:WBA) has a number of catalysts working in its favor. First and foremost is that fact that because of its status as the largest drugstore chain in the United States, it will surely profit from an aging population. Tens of millions of Americans are at or nearing retirement age, and as a person ages, their health-care needs increase. This will keep demand strong for Walgreen's products, especially in its pharmacy.

The market has woken up to these positive catalysts, and has sent shares of Walgreen soaring more than 50% over the past year. At the same time, its underlying fundamentals aren't as impressive as its share price performance. The end result is that Walgreen has a very lofty valuation that should be cause for concern over what the future holds. That's why you'd be wise to exercise a dose of caution before jumping into Walgreen at these levels.

A valuation that might make you ill
In addition, Walgreen is set to expand internationally, thanks to its $6.7 billion investment in Alliance Boots, the largest drugstore chain in the United Kingdom. Walgreen was solely a U.S.-based operator until the two parties combined two years ago. Immediate growth from the investment, in addition to cost synergies, is helping boost Walgreen's profitability.

However, it's also true that sometimes even a great company can become a poor investment if you pay too high a price for it. In Walgreen's case, that's a valid concern. The stock has rallied hugely over the past year and now holds a very lofty valuation. It's much more highly valued than the overall market as well as close competitor CVS Caremark (NYSE:CVS).

While Walgreen is a highly profitable and successful company operating in a business with good prospects for continued growth. That being said, here's why you should think twice before buying the stock at these levels.

Growth at an unreasonable price?
Walgreen is halfway through its current fiscal year, and the results so far are mixed. Revenue and earnings per share are up 5% and 22%, respectively. Walgreen's bottom line is getting a solid boost from the investment in Switzerland-based Alliance Boots . The combination has produced cost synergies totaling $236 million so far. Synergies are expected to reach approximately $400 million this year alone.

Plus, Walgreen is benefiting from strong prescription sales, which grew 7% last quarter. This is a great sign for Walgreen, since prescriptions make up nearly two-thirds of the company's total revenue. Moreover, Walgreen's share of all retail prescriptions rose 20 basis points last quarter, to 19%.

And yet, it seems like all this growth is more than priced into Walgreen's valuation. The stock has been on an unbelievable tear over the past year, which means you should be wary if you're considering buying in now.

After an incredible rally over the past year, Walgreen now trades for about 26 times trailing earnings. Walgreen's valuation multiple is well above its average multiple over the past several years. Walgreen's five-year average trailing P/E clocks in at 16 times, meaning it's now trading at a 62% premium to that. And, Walgreen's valuation stands at 19 times fiscal 2014 estimates.

This is a very aggressive valuation, especially considering analysts aren't expecting huge earnings growth this year. The median analyst expectation calls for $3.45 in adjusted earnings per share in fiscal 2014, which would represent 10% growth versus the previous year. That would certainly represent a successful year but not a performance warranting a 19 forward P/E multiple.

Its competitors are also not as aggressively valued as Walgreen. CVS is valued at about 20 times trailing earnings, a 23% discount to Walgreen. This is despite the fact that CVS posted 6% revenue growth and 23% earnings growth last quarter .

CVS is also valued at 15 times forward earnings estimates. It seems that there may be a disconnect between how the two close rivals are valued by Wall Street.

The Foolish bottom line
Walgreen is a highly profitable company that rewards its shareholders with reliable dividend increases every year. It's got a strong future ahead of it from an operational standpoint, thanks to the aging population in the United States and its investment in Alliance Boots. Walgreen is sure to profit from the rising health-care needs of the U.S. population and has international growth to look forward to as well.

However, it's rarely wise to throw caution to the wind when buying stocks. Walgreen's share price soared over the past year. Its earnings growth is expected to be fairly modest this year, which calls its huge rally into question. While it's easy to get swept up in a stock soaring to new highs seemingly on a daily basis, you may want to wait for a pullback before jumping into Walgreen right now.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends CVS Caremark. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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