Whole Foods' Wild Ride

June 10 was a rough day for Whole Foods (NASDAQ:WFMI) shareholders. The stock, which had closed at $117.97 the afternoon before, fell all the way down to $112.58 before bumping back up a bit before close. But that's all it was: one day in an otherwise upward climb for shareholders.

UBS Securities drove the day's drop. The firm downgraded Whole Foods from "neutral" to "reduce" because -- in UBS's opinion -- the price was outpacing the company's value. UBS wrote, "We think the current share price discounts long-term growth at levels which leave no room for failure, and we feel uncomfortable moving our price target any higher."

Fair enough. Whole Foods' stock trades at hefty multiples -- including a P/E ratio north of 50 -- that dwarf competitors such as Safeway (NYSE:SWY), not to mention other high-growth food retailers such as Rocky Mountain Chocolate Factory (NASDAQ:RMCF) and Starbucks (NASDAQ:SBUX). This fact is particularly extraordinary, given that Whole Foods sells groceries, a historically low-margin business. UBS went on, however, to note that Whole Foods continues to "see superior results."

This argument sounds a lot like the one Fool co-founder Tom Gardner cited when he sold twice-recommended Whole Foods from his Motley Fool Stock Advisor portfolio in May 2003. In his flash to subscribers at the time, Tom wrote, "Today, Whole Foods is trading north of $60, and I'm recommending that you sell the stock, based on valuation. I do not believe that the business has gotten weaker. In fact, it's grown stronger . I simply believe the stock is overvalued."

As usual, Tom saw the writing on the wall long before the folks on the Street did. Unfortunately, that foresight cost Tom a double this time, instead of earning him one.

A Rule Breaker rule-follower
I purchased Whole Foods for a very Peter Lynch-esque reason: I knew the product well, loved it, and saw more people shopping each week at my local Whole Foods. The stock was trading for approximately $45 at the time, and I heard the same dichotomy:

1. Whole Foods is a superior company.
2. Whole Foods is overvalued.

I can't dispute that, in a conservative discounted cash flow (DCF) evaluation, Whole Foods is overvalued by a long shot. But I'm still holding my Whole Foods shares, based on some of David Gardner's Rule Breaker criteria:

1. Top firm in an emerging industry
2. Sustainable advantage gained through momentum and visionary leadership
3. Strong past price appreciation
4. Good management
5. Strong consumer appeal
6. Called overvalued by the financial media

Under CEO John Mackey's leadership, Whole Foods has made the "crunchy" business of natural foods into a profitable phenomenon, silencing competitors such as Wild Oats (NASDAQ:OATS). That satisfies criteria one, two, and four. The stock is up more than 400% over the past five years (criteria three) and its customers are loyal to the company, the ideology, and the food (criteria five). And now we have UBS Securities et al: check off criteria six.

Imagine this
Whole Foods aims for $10 billion in sales by 2010. The company's current net profit margin is 4.3%, but I expect that to rise to 5% as Whole Foods realizes further efficiencies. If the company hits its sales target in 2010, net earnings will come in at approximately $500 million. That's a compounded annual growth rate of 25%: high, but not unrealistic given the results Whole Foods has been posting.

Account for 4% annual dilution, and Whole Foods' EPS in 2010 could come in around $6.33. By that time, the company's P/E multiple will have come down, but I expect it to stay above the industry average. In all, I'm holding a company that I believe could be worth $200 per share or more in 2010.

Although the above scenario is a bit of a shot in the dark, this Fool feels comfortable owning part of a well-managed company that is widely recognized as a class-A operation. With so many lesser companies trading on the market, why let a good one go?

Shopping for more companies that fit these criteria? Try a totally free 30-day trial of the Motley Fool Rule Breakers newsletter.

Tim Hanson owns shares of Whole Foods, but no other stock mentioned in this article. At The Motley Fool, no writer is too cool for disclosure . and Tim's pretty darn cool.