Better Buy: e.l.f. Beauty vs. Ulta Beauty

These fast-growing beauty stocks' performances are a perfect example that you don't have to chase hot tech stocks to make money in the stock market. A $500 investment made three years ago in shares of e.l.f. Beauty (NYSE: ELF) would have grown to an incredible $3,500 at current market prices. The same investment in Ulta Beauty (NASDAQ: ULTA) would be worth $1,300, which is enough to outperform the major market indexes.

Both companies have experienced a wave of demand since the pandemic, but while Ulta is continuing to grow at rates similar to its long-term operating history, e.l.f. has seen accelerating growth. Before drawing conclusions, let's dig deeper to see which of these beauties offers the best growth with the least amount of business risk.

Investment case for e.l.f. Beauty

In addition to e.l.f.-branded beauty products, the company also owns the W3ll People and Keys Soulcare brands. The company closed its e.l.f. brand stores in 2019 and focused on expanding its products across retail partners worldwide. It was perfect timing ahead of the pent-up demand that would follow the pandemic.

Over the last three years, e.l.f. Beauty's revenue exploded and hasn't looked back. The savings from closing its stores in 2019 and reinvestments in marketing and digital initiatives paid huge returns for investors. Revenue wasn't growing very fast before the pandemic, but since the fiscal first quarter of 2021 (which ended in March), revenue has more than doubled.

ELF Chart

e.l.f. data by YCharts.

What's more, management is hitting the right buttons operationally to deliver faster profit growth. For example, in the most recent quarter, gross margin improved a few percentage points to 67%. Most impressive is where this extra margin is coming from: price increases, cost savings, and a favorable shift to higher-margin products.

Free cash flow and net income have been growing to new highs and may continue doing so for the foreseeable future. Management raised its guidance for gross margin to be up 200 basis points, 25 basis points higher than the previous forecast. The reason for the revised guidance is the outperformance in the last quarter, growing sales in higher-margin products, and ongoing cost savings.

The favorable product mix shift and price increases speak to e.l.f.'s strong brand. Piper Sandler found that e.l.f. Beauty remains the top preferred makeup brand among teens, improving its market share by nine percentage points year over year.

One negative with the investment case is that the stock is priced for perfection. It trades at an expensive forward price-to-earnings ratio of 56, which means if the brand were to lose its popularity to competing brands, causing lower revenue growth, the stock could fall sharply.

Investment case for Ulta Beauty

Ulta Beauty was founded in 1990, so it has been around a long time and handled lots of competition. It operates a large footprint of over 1,300 stores and wins customers over with its huge selection of products from leading beauty brands, including e.l.f. Beauty.

The company has been growing steadily for years. The long record of double-digit growth speaks to a multibillion-dollar opportunity in the beauty and cosmetics markets.

ULTA Chart

ULTA data by YCharts.

A key competitive advantage for Ulta Beauty is its loyalty program with 40 million members, which leads to repeat purchases. Ulta also offers salon services, where stylists can recommend products to customers and drive incremental sales. The salon business delivered double-digit growth last quarter.

Its wide store footprint, e-commerce channel, loyalty program, and in-store services are a powerful combination of growth avenues. The company says 95% of its sales come from loyalty members. This aspect of its business model appears to be underappreciated by Wall Street right now.

Comparable store sales were up 15% last year, with earnings per share up an impressive 33%, but the stock trades at a reasonable valuation of 21 times this year's earnings estimate. That seems somewhat low for a business with consistent above-average growth over the last 10 years and a highly loyal customer base.

Which beauty stock is the better buy?

e.lf. is experiencing a hot streak of growth, but the risk is that it could be a trendy pick. Investors looking for a dependable growth stock for retirement don't need a hot stock that could flame out, but one that will continue producing returns for many years if not decades.

Ulta has lower business risk due to its mass-market retail footprint and selection of thousands of products. I like Ulta Beauty because it offers broader exposure to the growing cosmetics market without investors needing to bet their money on the continued growth of a single brand.

With Ulta Beauty stock, investors get above-average growth at a reasonable price. It may not outperform e.l.f. Beauty, but investors will sleep better at night not worrying about how long the latter can sustain its momentum.

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John Ballard has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Ulta Beauty. The Motley Fool has a disclosure policy.