Family Dollar stock: Should you bet your bottom dollar?

Q: Can Family Dollar fdo shares continue to do well?

A: As Americans learn again how to save money, many are driving to their nearest dollar store.

Family Dollar is a deep-discount retailer that sells consumable items, like food, and random consumer items, such as toys and home goods.

Through mid-February, shares of Family Dollar had been up 5%. And although they got trimmed in Wednesday's bloodletting, they were still not showing big losses for the year.

While other companies have been suffering big declines in profit, Family Dollar in January reported quarterly net income of 42 cents a share, up 13.5% from a year ago. That encouraged investors to think the company has the right message in an era of belt tightening.

But before you rush to buy shares, keep in mind that dollar stores haven't been the slam dunk you might expect.

Many investors believed in late 2008 that dollar stores were the place to be. In fact, shares of Family Dollar and its rivals Dollar Tree dltr and 99 Cents Only Stores ndn enjoyed runups last year. You can read about the big surges in the dollar stores' stocks last year.

But while investing seemed a sure-fire way to make money in 2008, investors have been pretty disappointed in 2009. Perhaps they went overboard last year, but shares of the dollar stores have been suffering. Through Tuesday, shares of 99 Cents Only Stores were down 27% and Dollar Tree's shares were off 8.4%.

Will Family Dollar's shares succumb to the same pressure? It's impossible to say. But it might be valuable to put the stock through the four steps considered as Ask Matt:

Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Family Dollar's trading history back to 1980, we see the company generated an average annual compound rate of price appreciation of 15.8%. That's pretty good if you consider the S&P 500 stock index posted a 10.2% average annual return in the same time frame, says IFA.com.

But here's the problem. To get that 55% higher return by investing in Family Dollar, you accepted higher risk — standard deviation — of 53.3 percentage points. That's much higher than the 15.3 percentage point risk of the S&P 500 during the period. So to get a 55% higher return, you took on 248% greater risk. You don't need to be a financial wizard to know that isn't a good tradeoff.

Step 2: Measure the stock's discounted cash flow. Some investors decide if a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs. When we run Family Dollar's stock, we find it's rated "neutral." In other words, the price is roughly equal to what the company is expected to generate in cash over its lifetime. Using this analysis, it would appear Family Dollar is neither cheap nor expensive.

Step 3: Compare the stock's current valuation to its historical range. BetterInvesting's Stock Selection Guide can help. If the company can increase earnings 11.5% a year the next five years, as analysts expect, that would leave the stock in the "buy" range. That's a green light for investors who believe the price-to-earnings ratio will return to historical norms.

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