The pros and cons of buying Woolworths shares in July

The Woolworths Group Ltd (ASX: WOW) share price has seen a strong performance in 2023 to date. It has risen by 20%, as we can see on the chart below.

Woolworths is best known for its supermarket business in Australia and New Zealand (where it’s called Countdown). However, it also has a business-to-business supply segment (called PFD), the retailer Big W, and other interests such as its majority stake in the company that owns pet supplies business Petstock.

Let’s have a look at what could be positive about Woolworths shares and why it may pay to be cautious.

Positives

We all need to eat so Woolworths has a very important place in the Australian economy. The growing Australian population means there are more mouths to feed, which is a positive for the company’s longer-term earnings.

On top of that, food inflation has been driving sales higher, which then boosts net profit after tax (NPAT).

In the company’s FY23 third quarter, it saw total sales growth of 8%, with 7.6% revenue growth for the Australian food division.

It also said that in the fourth quarter, up to the date of the update, sales trends had been “in line” with the third quarter, with solid sales growth for its food businesses.

As long as revenue and earnings keep growing over time, then the Woolworths share price could keep rising over the long term. In FY24, Commsec numbers suggest Woolworths’ earnings per share (EPS) could grow by around 8%.

Negatives

However, the success of Woolworths shares this year comes with a valuation risk. If a stock goes up a lot in a short amount of time, it pushes a company’s price/earnings (p/e) ratio higher and makes it more expensive.

If the p/e ratio goes higher and higher, more is being expected of the business, which could mean shorter-term underperformance from here.

Using the EPS on Commsec of $1.51 in FY24, this puts the Woolworths share price on a forward p/e ratio of over 26. That may seem a bit pricey for a business that’s only growing EPS in the single digits for the foreseeable future.

Woolworths shares have benefited from inflation, but there are many forces trying to reduce inflation. In turn, this would reduce growth for the supermarket business and could make the higher p/e ratio seem less appealing.

Foolish takeaway

After such a good first half of 2023, I’m not sure if Woolworths will be able to keep rising strongly in the shorter term, particularly if inflation slows down. But the business offers defensive earnings and I expect the profit can keep rising.