Looking at the stock price today compared to its recent financial results could mislead investors to believe that Dollar General stock is already fairly priced.
In reality, there are several reasons to believe that the company is on a road to recovery, paving the way for higher profits and a higher stock price.
Shares of retail chain Dollar General(NYSE: DG) dropped 45% in 2023 and 44% in 2024 as investors fretted over rising unemployment, macroeconomic uncertainty from tariffs, and the retailer's own plunging profit margins. In January, it hit rock bottom.
Dollar General stock is stunningly up more than 60% since. Investors today are left wondering whether it's still a value play today or whether the value train already left the station.
Image source: Dollar General.
As of this writing, Dollar General has earned nearly $1.2 billion in net profits over the last 12 months, and the total value of its stock -- its market cap -- is just north of $25 billion. This means that it trades at almost 22 times its profit. In other words, the price-to-earnings (P/E) ratio is 22.
On one hand, this means that Dollar General stock doesn't look like a value play today. After all, over the last decade, it's traded at an average P/E ratio of less than 20. From this perspective, it's trading at a more expensive valuation than normal.
On the other hand, this chart doesn't tell the entire story. And the rest of the story has me believing that Dollar General is indeed an enticing value play for investors today. Here's why.
Why Dollar General stock is a value play
Generally speaking, stocks go up when earnings per share (EPS) increase. To be sure, one of the easiest ways to grow EPS is with revenue growth. But there are companies that still manage to grow EPS at a nice clip by other means, and this can lead to good stock performance.
This isn't a hard rule. After all, gaming platform Roblox is worth over $60 billion and has never reported positive EPS. But as a general rule, long-term EPS growth matters when it comes to a stock's price.
I'll be clear: I believe that Dollar General is in a great position to materially grow its EPS over the next five years at least. And I believe the stock is a value play today in light of its future profit potential.
Dollar General's profits are under pressure right now. But there are multiple reasons to believe that the pressure is temporary. Allow me to hit the big ones.
First, Dollar General's management misstepped and bought too much inventory back in 2022. This is clearly seen in the chart below -- inventory growth suddenly flew right past revenue growth.
The result of this miscalculation was devastating for Dollar General's profits. Besides merchandise getting damaged and stolen, management also had to lower prices to quickly downsize. And this hurt the company's profits. But now, with inventory returning to more appropriate levels, this headwind should abate, leading the way to better pricing and higher profit margins.
Second, Dollar General's customers have changed their shopping habits recently, which also impacts profits in the near term. About a year ago, management shared that most of its customers are low-income and anticipate missing credit card payments. This meant they were buying more food and less discretionary items.
The problem for Dollar General is that food items tend to have lower profit margins than discretionary items. While it's questionable whether macroeconomic conditions have yet improved since management shared this, it's reasonable to assume that they eventually will. A normalized mix of food items and discretionary purchases could help profit margins improve as well.
There are more reasons to believe that Dollar General's profits will improve over the next five years or more. For example, sales for the company's private label brands are steadily growing, which can have better margins. But suffice it to say that there are multiple drivers for Dollar General's profits in coming years.
The chart below shows that Dollar General's profit margin is about half of what its 10-year average is. I'm not necessarily hoping that the company does better than ever. On the contrary, simply returning to normal margins within the next few years would allow profits to double.
Keep in mind that I'm only talking about Dollar General's higher profits due to normalized profit margins. This doesn't account for the incremental profit potential from opening new locations. Moreover, its same-store sales usually increase, leading to more revenue growth.
Dollar General stock is fairly priced today compared to profits that are under pressure. But it's a value play for those who assume that its stores remain relevant, its top line further grows, and its profit margins return to normal.
I personally assume all of those things. This is why Dollar General stock is a value play that I'm still happy to hold in my own stock portfolio today.
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