Dollar General (NYSE:DG) stock has gained 180% over the last five years, crushing the S&P 500. Dollar General's gross margin is near a decade high and net income is higher than it has ever been. Dollar Tree (NASDAQ:DLTR) and Family Dollar (NYSE:FDO) are at similar high points. Could this be the top of the cycle, or will Dollar General continue its remarkable growth for years to come? Let's investigate whether it's time to add Dollar General stock to your portfolio. 

Biggest company in the industry

Dollar General had 11,215 stores in 40 states at the end of February 2014. That's almost as many as Family Dollar and Dollar Tree have combined. If Dollar Tree acquires Family Dollar, the combined company would have roughly 13,000 stores.

Although Dollar General could benefit from acquiring Family Dollar, it doesn't need to win the battle for Family Dollar in order to grow. Dollar General plans to add a total of 700 stores in fiscal 2014, which would be a 6% increase to its total store count. It is relocating or remodeling several hundred more, which could boost comparable-store sales performance. Dollar General controls its own destiny.

Revenue and profitability

Dollar General's gross profitability is already at an elevated level, but it could go higher still as the company is reserving more shelf space for store-brand products, which garner a higher margin at a lower price than name-brand products.

At the same time, however, Dollar General's same-store sales growth is decelerating. After growing 6% in 2011, same-store sales grew just 4.7% in 2012 and 3.3% in 2013. Management expects 3% to 3.5% same-store sales growth in fiscal 2014.

Dg Rev Growth And Profit

Dollar General's revenue growth is decelerating even as its gross margin sits near a decade high. Data source: Morningstar

It is unlikely that Dollar General's gross margin will expand enough to offset a continued deceleration in revenue growth. Therefore, it is important to the bull thesis that the company continues opening new stores each year and maintains its current level of same-store sales growth.

Valuation

Dollar General's viability as an investment that promises safety of principal and a satisfactory return hinges on whether discount chain profitability will remain at current levels or fall back to long-term averages. Dollar General, Family Dollar, and Dollar Tree have each been more profitable in the five years since the Great Recession than they were in the five years prior to the recession.

Company

Price/Earnings Ratio

Price/Sales

5-Year Avg. EBIT Margin 

10-Year Avg. EBIT Margin 

Dollar General 

20

1.1

9.6%

7.3%

Family Dollar 

23

0.9

7%

6.5%

Dollar Tree 

20

1.4

11.4%

9.8%

If Dollar General turns each dollar of sales into $0.10 of operating profit, then paying 1.1 times sales is like paying 11 times pre-tax profit. That's a pretty good deal for a company that expects to increase its store base by 6% and its same-store sales by 3%. However, if the good times come to an end and Dollar General returns to a 7.3% operating margin, paying 1.1 times sales would be like paying 15 times pre-tax profit. That's a more difficult value proposition to evaluate, especially since same-store sales growth would likely slow down in such an environment.

In any case, Dollar Tree may be the more attractive stock.   If the last five years is the best guide to the future, then Dollar Tree trades at 12 times pre-tax profit. If industry margins revert to the 10-year average, then Dollar Tree trades at 14 times pre-tax profit. This could become more attractive if it acquires Family Dollar and realizes significant synergies. Therefore, Dollar General does not look like the best candidate to add to your portfolio at its current stock price.

Foolish takeaway

As a rule of thumb, you should not envision a future that is better than the past unless you have a really good reason. Dollar General's same-store sales growth is decelerating and its gross margin is starting to come down a bit, so a reversion to the long-term mean is not out of the question. At 1.1 times sales, Dollar General is not especially attractive if profits revert to the long-term average; if anything, Dollar Tree looks like the cheaper stock. Dollar General isn't a fat pitch, so picky investors may want to avoid it for now.

Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.