Good companies don't always make good investments. Investors need to consider risk relative to upside potential, and stock valuations sometimes reflect too much optimism for high-quality businesses.
These five stocks are popular for good reasons, but it's wise to consider the risks before getting involved. Let's take a look.
1. Tesla
Tesla (TSLA +1.79%) deserves a ton of credit for disrupting the automobile industry-innovating electric vehicle (EV) technology. However, its growth prospects created hype around the stock, creating risk for investors. If the company's financial results don't live up to lofty expectations, then shareholders are likely to feel pain. That's been on display since last year, as Tesla shares have dropped more than 40%. High interest rates, coupled with a slowing economy, discourage investors from taking more risk, which is bad news for growth stocks with expensive valuations.
TSLA PE Ratio (Forward) data by YCharts.
Tesla leads the U.S. electric vehicle market with roughly 50% share, but its dominance over the market is declining. The company faces fierce competition from the traditional automaker giants, along with foreign and domestic EV start-ups. This is leading to price competition and profit margin erosion, causing Ford Motor Company and General Motors to even rethink their EV development strategies.
Despite getting cheaper over the past two years, Tesla's forward P/E ratio is still nearly 75 and its price-to-sales ratio is over 7.5. Those are high enough to create significant volatility risk. Tesla still has the potential to deliver significant returns, but investors should recognize the risks posed by macroeconomic issues and competitive pressures.
Image source: Getty Images.
2. Wingstop
Wingstop (WING 3.26%) has a lot going for it, but its valuation is steep. The takeout restaurant chain trades with a forward 1-year P/E ratio of around 75 and a trailing price-to-sales ratio close to 13. Strong fundamentals can justify premium valuation in any industry, but these ratios are more associated with tech companies sporting explosive growth rates. Wingstop operates in a highly competitive, mature industry.
The company delivered 30% revenue growth last quarter, spurred on by new store openings and strong same-store sales growth. Wingstop's franchise model allows it to achieve an impressive 25% operating profit margin by removing some of the operational burden of company-owned restaurants. These are impressive fundamental performance metrics, and the company should be a solid cash-flow generator for years to come.
Valuation is the issue with Wingstop. Its PEG ratio, which adjusts P/E for growth, is close to 3.5, which is quite high for this industry. There are high-quality companies with strong growth potential that are much cheaper PEG ratios. Wingstop's low 0.4% dividend ratio doesn't move the needle for income investors. This stock's price assumes a lot of strong future performance.
3. Walmart
Walmart (WMT +0.18%) is another operationally strong company with a weaker investment narrative at the moment. The stock's forward P/E ratio is around 23. That's not expensive, but its long-term earnings growth rate is around 5%. The market isn't pricing the diverse, mature business to achieve explosive growth, and so investors should not consider its stock as a growth investment.
Instead, Walmart is great for providing reliable cash flows, which it returns to investors in the form of dividends. The company is among the greatest ever in terms of maximizing efficiency and maintaining enormous market share, so it's considered a safe haven for risk-averse investors. Uncertainty over the past two years has pushed investors disproportionately into a small number of high-quality stocks, and Walmart is one of them. As a result, its dividend yield below 1.5% -- that's low for a volatile asset when three-year Treasury notes yield 5%.
Walmart is an operationally sound company, but the stock's current valuation suggests there are other securities more efficient for growth, investment income, and for protecting value.
4. Vornado Realty Trust
Vornado Realty Trust (VNO 1.37%) is a real estate investment trust (REIT) that owns a portfolio of properties, most of which are office buildings in New York City. That portfolio puts the company on the wrong side of long-term trends that its valuation might not properly reflect.
People are slowly returning offices for work, but it's hard to ignore several key stats in New York. The city's population has dropped in recent years, driven by people seeking a cheaper cost of living, lower taxes, or a different lifestyle. Manhattan's office vacancy rate stabilized in the past few quarters, but it's still high. Many workers have transitioned to permanently remote roles, and new start-ups are more likely than ever to have fully remote teams. That discourages people from living in expensive population centers, and it's crushing demand for expensive office space.
Vornado has experienced declining funds from operations (FFO), and it suspended its dividend earlier this year. Stock screeners might indicate that the REIT pays a 4% dividend yield, but that's not the case moving forward. In the meantime, Vornado shareholders need to rely on debt reduction and share buybacks to increase equity value, and people generally own REITs for those reasons.
5. Lowe's
Lowe's (LOW 0.41%) is dealing with a variety of short-term pressures, but its valuation might not reflect those issues right now.
High interest rates and inflation have created a challenging environment for Lowe's and its peers. Consumers' buying power has tumbled over the past two years, while borrowing costs have risen. The job market remains relatively strong, but some industries have been hit hard by layoffs. Economic data and corporate earnings show a pullback on consumer spending on retail goods, discretionary items, and big-ticket items. Industries that are heavily influenced by interest rates, such as housing and automobile sales, are also dealing with significant weakness. This all translates to weak demand for Lowe's, which is impacting financial results.
LOW Revenue (TTM) data by YCharts.
Lowe's 2.3% dividend yield isn't very exciting, and it's hard to see a catalyst for the stock in the near term. The macro challenges are unlikely to go away for the next few quarters at a minimum, and the company's financial leverage makes a significant dividend hike unlikely during a lean period. Long-term catalysts exist for the housing and improvement sector, but Home Depot might provide better exposure to those trends.
