Everyone has to eat, right? Preferably healthily, if Omnivore's Dilemma by Michael Pollan is to be believed––it's the best-selling book that helped catalyze the burgeoning food awareness movement. Therefore the supermarket industry is a good one because there's no danger of it going out of business; and the never expiring guarantee of the supermarket explains why people invest in them. But which one should you pick? Safeway (UNKNOWN:SWY.DL)? Or Kroger (NYSE:KR)? Or a new-comer like Sprout's Market (NASDAQ:SFM)? Or Whole Foods? (NASDAQ:WFM)
An alternative to the P/E Ratio
Investors are often taught that they should look to the P/E ratio to help them make their investing decision. That's because you get to find out what price you're paying (the P in the numerator) compared to the earnings the company generates (the E in the denominator). And the lower the ratio, the better the bargain: you get to pay less per share to gain more of the company's profits.
Safeway would be the winner in our group with a P/E of 15.25, compared to Kroger's 16.7, Whole Foods Market's 27.42, and Sprout's Market's 63.84. But experienced investors know this ratio doesn't tell the whole story. That's because a company's profits do not equal the cold hard cash that ends up in the cash register. Why? Lots of reasons, but simply put, there are bills to pay and investments to make, and just because you made a business profit doesn't mean there is money left over once the final tallies are made. Wouldn't it be nice if there was a number that gave us this information––how much actual money did the company make that it also got to keep?
Free cash flow
You're in luck--there is such a measure, and it is called "free cash flow." It is found by looking at a company's cash-flow statement and finding the cash from operating activities line (how much money the company made thanks to its business acumen). Next, subtract the capital expenditures (how much the company invested in itself to keep the business well-oiled and expanding). Whatever is left over Warren Buffet likes to call "owner's earnings" because the money is free for management to decide what to do with. Therefore if it wants to reinvest even more in its business above and beyond current levels, it is "free" to do that.
Why Whole Foods' fell
Whole Foods' stock recently dropped 20% because there are more competitors than ever in the organic foods supermarket space. The worry, of course, is that with encroaching competitors there will be more margin pressure on Whole Foods and ultimately less profit for its shareholders. The market is implicitly making the following assumption: despite being the first-mover and biggest brand name in the industry, Whole Foods will not do anything proactive against the competition, and despite a team of managers who have a proven track-record of success, they will be happy to sit on their hands. Do you believe that?
Why free cash flow will save the day
Since it's clear Whole Foods won't idly sit around and let the new kids on the playground steal its pail and shovel, Whole Foods will need money to increase its marketing spending, its store expansion rate, all the while maintaining and improving the wonderful store experience its shoppers have come to love. Isn't it fortunate, therefore, that Whole Foods makes $1.3 million in free cash flow per store, compared to Kroger's $398,000 , Safeway's $357,000, and Sprout Market's $430,000? If what is needed is greater marketing visibility about Whole Foods' new lower-price initiatives, Whole Foods has all sorts of money at its discretion to accomplish that goal. And because it is by far the least leveraged company out of the bunch––with a measly 1.54 debt to equity ratio that translates as lots of money and little debt––Whole Foods has a tremendous growth runway ahead and a colossal amount of financing possibilities with which to fund it. The same, alas, cannot be said of its competitors which are laboring under mounds of IOU's.
Since you have a choice in what you invest in, why not invest in the industry leader with more free cash at its disposal than its competitors? At a newly minted bargain price? Who's hungry?