Companies that take radical steps in pursuit of growth are often accorded very rich valuations. Case in point: Amazon.com, Inc. (Nasdaq: AMZN), which as I recently wrote, has a valuation that bears no relation to it’s financial measures, such as free cash flow.

#-ad_banner-#In one respect, such companies are fortunate. In the absence of traditional valuation measurements, they are often given a free pass from a fundamental analysis perspective. Of course, when a once-hot growth company starts to mature, such valuations start to matter a lot. A deep look at grocer Whole Foods Market, Inc. (NYSE: WFM) provides an example of an absurdly overvalued stock — one you should avoid or outright short.

The Air Pocket Becomes Permanent
Roughly a year ago, shares of Whole Foods hit an air pocket as heightened competition from firms such as The Fresh Market, Inc. (Nasdaq: TFM) and Sprouts Farmers Market, Inc. (Nasdaq: SFM) led to slowing growth. Yet, in recent months, shares of Whole Foods have staged a remarkable rebound.

The explanation for this stock’s sudden renaissance is quite simple: Whole Foods has delivered 8% same stores sales growth and 23% annual profit growth since 1994, and investors have recently come to think that this company can continue to boost profits and same store sales at an impressive pace in coming years as well.

“Management is not sitting on its laurels and is confident in the company’s ability to innovate and evolve to meet the needs of customers while staying ahead of competition,” wrote analysts at Goldman Sachs, who rate shares as neutral, with a $51 price target. Yet these analysts add that “recent initiatives have yet to drive a substantial pick-up in (same-store) comps relative to the industry and the company’s margin trajectory is less certain going forward given peak levels and new competition.”

In late February, Whole Foods’ management held the company’s first ever “analyst day” and laid out a series of plans to move the revenue needle. Management’s efforts to reinvigorate growth include: a first-ever national ad campaign, refurbishing 200 stores annually, more private label items, investments in social media and loyalty programs and a greater emphasis on in-store dining.

Perhaps the greatest driver of all are plans for robust store expansion in all of its key markets — boosting the store count to 1,200, from a current 410. Trouble is that’s the same view (and strategy) held by its health-oriented rivals The Fresh Market and Sprout’s.

Both competitors went public in 2010 and 2013, respectively, and they used their IPO proceeds to fuel aggressive store expansions. As the companies did this, they started creating more options for the shoppers that historically were loyal Whole Foods. A competitive market resulted in tougher pricing and what now appears to be a steady erosion in Whole Foods’ earnings before interest, taxes, and depreciation, or EBITDA, margins.

Frankly, management now understands that competition — and growth constraints — may be more pronounced than they are willing to acknowledge. In May 2014, the company guided analysts to expect 6% same-store sales growth, and 15% earnings per share, or EPS, growth over the next five years. Fast forward to the recent analyst meeting, and management decided to avoid explicit growth targets.

That led analysts at Cantor Fitzgerald to think that the guidance issued last year no longer holds water. “At this time, we think those (projected) growth rates appear aggressive. In terms of substance, we think it’s important to keep in mind that there’s been no acceleration in the rate of core earnings growth over the past three quarters, with net income growth consistently in the range of 5-6% over that time,” note analysts at Cantor Fitzgerald, who rate shares a sell, with a $33 price target.

Although Whole Foods saw same store sales rebound to 4.5% in the December quarter from 3.1% in the September quarter, it’s important to note that higher spending is impeding profit growth. Net income rose 6% year over year to $167 million ($0.46 a share) in the December quarter. More telling, when results were released in mid-February, management guided for same-store sales growth in the low- to mid-single digits for the remainder of fiscal 2015.

Even if you assume that 5% same store sales growth and an expansion in the store base will yield 10-to-12% sales growth in the next few years (as Goldman Sach’s forecast suggests), then shares still look awfully expensive. They are valued at nearly 30 times fiscal 2016 EPS forecasts, well above the 10-to-12% projected EPS growth. Said another way, does this stock deserve a PEG (P/E divided by the earnings growth rate) of around 3? No, they don’t.

Risks To Consider: As an upside risk, an improving economy could lead shoppers to become less price-sensitive and more willing to accept Whole Foods’ premium pricing model.

Action To Take –> Shares of Whole Foods have staged a remarkable rebound simply because same-store sales didn’t fall to zero, as the trajectory seemed to imply last summer. But this is a mature company, operating in saturated markets, with well-financed younger competitors. Management has a remarkable historical track record, but there is no longer any reason to justify such a high price-to-earnings ratio. As the reality of tepid growth sets in over coming quarters, look for the forward multiple to shrink to around 20, implying a $40 target price, roughly 30% downside. This stock is one of the more transparent short sale candidates of any stock in the S&P 500.

StreetAuthority is proud to present its first system that incorporates short selling. We call it Trader’s Edge, because it uses system of going long three fundamentally sound companies and going short three companies primed to drop. This has allowed us to capitalize on market trends no matter which way the market moves — we even completely avoided the effects of the Great Recession. To learn more about this system, click here.