Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Are investors not giving retailer Five Below (NASDAQ:FIVE) enough credit?

Last quarter, this inflation-adjusted twist on the "five and dime" store business model missed on sales (up 20%) but beat on earnings (up 15%). That's an impressive performance in a troubled economy flirting with recession. And yet, with a recent share price near $127, Five Below stock has only booked a gain of less than 4% over the last 52 weeks.

Investment banker William Blair thinks that's a mistake, and that Five Below shares should actually be worth much more. So this morning, the analyst announced it is initiating coverage of Five Below with an outperform rating.

Here's what you need to know.

Five dice labeled buy and sell on top of an LCD screen displaying charts and numbers

Image source: Getty Images.

Hunting for treasure

What does William Blair see in Five Below?

"[S]mallstore convenience [and] extreme value on both discretionary and basic items," top the analyst's list of likes about Five Below's business, and it praises management for underpricing the competition "on identical items."  

William Blair also applauds Five Below's novel method of grouping its products into "eight distinct merchandise 'worlds' all under one roof," noting that this user-friendly organization of the store is "unique within retail, in our estimation."

And of course, the analyst makes the usual argument found in any note recommending a dollar store chain: To wit, that Five Below's constantly changing inventory isn't something that will upset regular customers searching for something that's no longer there, but should rather be viewed as offering shoppers "a regularly changing and highly edited/curated ... treasure-hunt."

Dollars and cents

Well and good. Five Below offers shoppers a "unique" experience that differentiates its stores from the competition. But what about the stock?

Like its shopping experience, the retailer's financials are "attractive," argues William Blair in its note covered by TheFly.com. The balance sheet is "pristine," with "strong and consistent unit economics," and cash flow is "solid" despite high levels of spending to expand the store count. In the analyst's estimation, Five Below is well positioned to grow its sales in the high teens to low 20s percentage annually.

And most other analysts agree. Consensus estimates collated by S&P Global Market Intelligence have Five Below growing its sales at better than 20% annually over the next three years at least, and GAAP earnings are expected to almost match that rate. But there is your first clue that something may be amiss at Five Below.

All else being equal, shouldn't greater sales result in economies of scale, efficiencies of operation, and earnings growing faster than sales? I would think so, and yet, that's not what most analysts are projecting for Five Below. So why not?

One reason, I suspect, is that the bulk of Five Below's sales growth comes not from stores performing strongly once built, but from simply building new stores. As my fellow Fool.com contributor John Ballard pointed out last month when reviewing this fast-growing retailer's financials, while companywide sales grew a very respectable 20% year over year in Q2, "comparable-sales growth" -- that's sales growth at stores already open for more than one year -- "clocked in lower than expectations at 1.4%." To keep growth going, Five Below "is on track to open 150 new stores for the full year, which would bring the total store count to 900 by the end of 2019."

And here's the thing: Opening all those stores costs money. In fact, S&P Global data shows that capital spending (part of which is money spent to open new stores) has risen steadily for the past five straight years. Over the last 12 months, capex topped $167 million, eating up almost all of the $187 million in cash flow that Five Below produced, and leaving the company with actual cash profits (free cash flow) of only $20 million -- far less than the $157 million in net "profit" that it reported for the period.

What it means to investors

Suffice it to say, it's this free cash flow number that worries me most about Five Below stock.

You see, even giving management credit for the full $157 million in earnings it reported under GAAP, at $7 billion in market capitalization, Five Below shares sell for a whopping 45 times earnings. That's already pretty pricey, even assuming the company grows earnings at the 21% annualized rate that Wall Street is projecting.

But if you value Five Below on its free cash flow rather than its GAAP earnings, the stock's multiple balloons to 350 times free cash flow, an insanely rich multiple to pay (in my view) for what's essentially a dollar store chain with a twist.

So I cannot agree with William Blair's view that Five Below will outperform the market from today's prices. While not all my colleagues will agree with me on this one, I expect Five to be a Below-average performer from here on out.