Five Below (FIVE -1.12%) is a retail chain selling inexpensive goods primarily to teens and preteens. It has over 1,200 locations in 40 states, and it went public via an initial public offering (IPO) in July 2012. And from its IPO price of $17 per share, it's up about 9.5 times in value, trouncing the 200% return of the S&P 500 over this time.
The question on everyone's mind, however, is whether Five Below stock can trounce the market again. To be clear, I'm not sure it will return as much over the next 10 years as it did over the previous 10. However, looking to 2025, I do indeed believe Five Below stock can outperform the return of the S&P 500 if it can hit management's (realistic) profitability goal.
Why Five Below was a market-beater
I want to explain why I expect Five Below stock to beat the market. But first, you must understand a couple of things. First: It's important to take a long-term perspective with stocks. Consider that Five Below's sales have shown a 23% compound annual growth rate (CAGR) over the past six years. That's stellar, but there's a caveat.
Image source: Five Below.
That stellar top-line growth hasn't been entirely consistent. For example, in the fourth quarter of 2019 (the oh-so-important holiday quarter), the company's same-store sales fell 2.2% year over year. Upon reporting this decline, the stock tanked because investors looked at this short-term trend and inferred that Five Below's growth story was over. It wasn't.
This little anecdote hopefully illustrates the importance of thinking in terms of years rather than quarters when it comes to investing.
The second thing everyone needs to understand is that (over the long-term horizon I'm advocating for) profits are the largest contributing factor for a stock's performance. Let's consider the chart below, which displays the 10-year trend for S&P 500 companies.
S&P 500 earnings per share. Data by YCharts.
The chart does not demonstrate a perfect 1-to-1 cause-and-effect dynamic between earnings per share (EPS) and stock price. But it does suggest a strong relationship. And the relationship between profits and stock price is a stronger relationship than the one with sales, book value, or valuation.
Therefore, I believe that over the long term, earnings are the most useful factor for predicting stock prices. And this belief is further backed up by Five Below's own chart over the past five years.
FIVE data by YCharts. TTM = trailing 12 months.
At its simplest, Five Below stock is going up because its profits are going up. And it's a powerful trend that management expects to continue.
Why Five Below can be a market-beater yet again
Five Below management believes it can open up 1,000 new stores by the end of 2025. And it believes it can double sales. Let's start with this.
Opening 1,000 stores is entirely realistic. Over the past six years, Five Below has opened new locations at a 18% CAGR. Considering it has 1,200 stores right now, opening 1,000 locations over the next four years represents a deceleration of its pace of the past six years.
Furthermore, consider that Five Below recently opened new distribution centers that will allow it to support 2,000 total locations. In other words, it already has most of the infrastructure it needs to support its four-year expansion plan.
Opening 1,000 stores will increase Five Below's store count by just over 80%. Management believes overall sales will double. Therefore, most of the sales growth will come from new locations and only modest same-store sales growth is needed to double sales. Again, this seems more than reasonable.
Which finally brings us to Five Below's profits. In management's plan, it expects to "more than double" its EPS by 2025. If that one thing happens, I believe Five Below stock will beat the market; we've already seen that profits drive stock prices over long time periods.
To more than double EPS, Five Below would not only have to double its revenue by growing its store count and growing sales per location, it would also need to see margins improve. And I also believe this to be possible. Consider that it will need to invest less money in new distribution centers because of the investments it's already made. And more sales per location helps it gain operating leverage since the cost of running a store is largely fixed.
If the S&P 500 returns 10% annually through 2025 (historically about average), it would go up roughly 46%. If Five Below more than doubles its EPS, its valuation could go down some and still beat the market. Therefore, if you're looking for a strong addition to a diversified portfolio, consider adding Five Below stock.
