Own Dollar General? Hurry and take this advice before earnings

Key Points

• Dollar General could be the stock to take off your watchlist this quarter, or at least the one position you need to hedge urgently. 
• Understanding where the sector stands, it looks like markets are not too confident about the upcoming earnings results for the firm and are instead placing their bets on 'better' options. 
• Analysts agree that you could have a dead cat bounce pattern on your hands.

With the end of the year approaching, you need to make sure your portfolio is in the best shape possible. Considering that some investors will have to deal with a tax burden in a couple of months, cutting some losses - or preventing them - is the name of the game today.

Some on Wall Street have decided to take the rest of the year off to enjoy the holidays and escape the ups and downs of financial markets. Hence, the VIX is at its lowest level since 2019, implying that not much is happening in the market today. Not much except for a dead cat bounce on Dollar General NYSE: DG shares.

Part of the retail stock universe, Dollar General is not in a great position relative to some of its peers, as markets are laying down clear warning signs of a potentially disappointing quarter announcement coming up. If you own it, you'll want to read this so you can hedge away any potential risks.

Plain and simple 

Taking the sector as a whole, you can use MarketBeat's stock screener to spread out the following metrics for all the stocks in the space. Namely, the forward price-to-earnings ratio seeks to place a value on the expected earnings a business will push out in the next twelve months.

This one may sound a bit controversial for those value investors out there, but you aren't here to follow the average path, right? The big gains, or more importantly, avoiding the significant losses, come from taking the path less traveled.

Taking the sector as a whole, with close competitors like Costco Wholesale NASDAQ: COST and Target NYSE: TGT, or even Dollar Tree NASDAQ: DLTR, if you are looking for a more 'apples to apples' comparison, you can gauge where the market sentiment is with regards to the future earnings growth of these firms.

As an average, the sector is trading at a forward P/E of 21.7x, which you can use as a benchmark against which to compare your stocks of interest. Here's some advice: The more expensive they are next to that average, the better. Why? The answer may be too simple to even take seriously.

Target sits at the bottom of the group, at a 14.5x multiple to the average, or a 33.4% discount. Dollar General comes in second place at a 22.0% discount with its 16.9x valuation. The most valuable company here is, unsurprisingly, Costco; a valuation of 34.5x will place it 58.7% above the sector.

Despite what you may think, there's a very clear gap driving these valuations, and the results may surprise you.

Gameplan 

Why is this not guidance pointing to the pitfalls of Target, which happens to be the least-valued stock in the group? The answer comes down to the expected earnings growth and the price-to-earnings-growth ratio in itself as well.

You see, the PEG ratio is the way that markets gauge whether a stock is too expensive compared to how fast its earnings are expected to grow since you can always overpay even for a good thing. So here's how you break it down.

Target analysts expect earnings growth of 9.0%, while Dollar General sees only 2.1% (the lowest of the group). Dollar Tree and Costco come at higher rates of 17.6% and 8.5%, respectively.

So it is clear that Dollar General should be - and almost is - the least valuable stock in the group based on lackluster growth, but how can you make sure? Dollar General's PEG ratio is 7.9x... Good or bad?

A PEG ratio below 1.0x is considered 'cheap,' meaning that a stock's P/E ratio is low compared to its earnings growth. On the other hand, a PEG ratio above 1.0x can be considered overpaying for the current growth expectations, so a 7.9x is just obscene.

Dollar Tree, which can be the closest comparison here, trades at a 1.0x PEG ratio, which could be considered fairly valued. Now, Costco trades at a 4.0x ratio; isn't that also overextended? Considering the company's size and brand moat, you can see why investors like Warren Buffett would be willing to overpay.

But wait, there's more. A recent lawsuit has just hit Dollar General right before its earnings announcement. The lawsuit, coupled with a low valuation and disappointing earnings growth, provides the perfect pessimistic storm to bring the stock back down from its recent dead cat bounce.

Want some advice? Take the stock off your watchlist for now and wait to see what the quarter brings. But it is highly likely that the stock will get worse before it gets better. An analyst upside of 6.6% is not worth the headache today.