In spite of the fact that their products are relatively easy to understand and relate to, retail companies can be difficult for the average investor to analyze. But the good news is that if an investor knows what metrics to look for, the stock selection process will be much easier.

To that end, below is a list of nine tips that all investors should use when determining whether a retail stock is worth the investment:

1. Visit the Stores
An investor can learn a lot simply by perusing the aisles of a particular retail location. Information that can be found readily include the store's layout, the availability and appearance of the merchandise, and the prices being charged.

As a rule, investors should look favorably upon stores that are well-lit, sell timely and fashionable merchandise, have neat displays and offer very few discount items.

The savvy investor will also take note of the foot traffic in store. Is it crowded? Are there lines at the registers? Are shoppers buying big-ticket items in bulk, or merely lurking around the discount racks hunting for bargains? In fact, these are all questions that the investor should ponder that will help him or her determine the overall health of the company.

2. Analyze Promotional Activities
Is the company promoting its merchandise to drive foot traffic or earnings? Does it try to get every last dollar it can out of the consumer out of desperation or weakness (because it can't sell it wares)? This is an important point to clarify because companies that are willing to sell their merchandise at deep discounts just to unload it before the end of a selling season often do so at the expense of margins and earnings.

Visiting the store, and examining the weekly circulars, can give the investor an idea of whether the company is begging shoppers, literally or figuratively, to come into the store, which can be a sign that the company is headed toward an earnings shortfall.

3. Examine Gross Margin Trends
Investors should look for both sequential and year-over-year growth in gross margins. However, investors should also keep seasonality effects in mind. Most retailers see a surge in revenues in the fourth quarter compared to the third quarter, because of the holiday season. In any case, gross margin trends will give the investor a better idea of how good current and/or future period earnings will be.

Investors should be extremely wary of companies that are experiencing a decline in gross margins (either sequentially or year-over-year). This is because those companies are probably experiencing a decline in revenue or foot traffic, an increase in product costs and/or heavy markdowns of their merchandise, all of which can be detrimental to earnings growth.

4. Hone in on Sales-Per-Square-Foot Data
This metric (that some companies reveal in conference calls, and others reveal in their 10-K or 10-Q) is a reliable indicator of how good management is at using store space and allocating resources, the higher the sales-per-square-foot the better.

For example, Coach's sales-per-square-foot was more than $1,800 in 2012. This is quite good, given that some of its competitors, like Michael Kors, for example, reported sales-per-square-foot of around $1,400. In other words, using this metric, an investor could assume that Coach's management is making better use of its floor space than its counterparts at Kmart. It may also suggest that Walmart has a better merchandise mix, and may have more flexibility with respect to its margins, though other factors would have to be examined to determine whether this is the case.

5. Examine Inventory/Receivable Trends
Investors should examine sequential and year-over-year trends in both inventories and accounts receivable. If all is well, these two accounts should be growing at about the same pace as revenues. However, if inventories are growing at a faster rate than revenues, it may indicate that the company is unable to sell certain merchandise. Unfortunately, when this happens, companies are usually left with just two options - they can either sell the merchandise at a really low price point and sacrifice margins, or they can write off the merchandise altogether. (Which also could have a significant adverse impact on earnings.)

If receivables are growing at a faster rate than revenues, it may indicate that the company is not getting paid on a timely basis. This may lead to a deceleration in sales in some future period. In short, changes in the inventory and receivable accounts should garner a great deal of attention, because they can often signal future fluctuations in revenue and earnings.

6. Examine Same-Store-Sales Data Closely
This is the most important metric in retail sales analysis. Same-store-sales data reveals how a store, or a number of stores, fares on a period-to-period basis. Ideally, an investor would like to see both sequential and year-over-year same-store-sales growth. Such an increase would indicate that the company's concept is working and its merchandise is fresh.

Conversely, if same-store-sales numbers are decelerating, it may signify that a host of problems exist, such as increased competition, a poor merchandise mix or a number of other factors that could be limiting foot traffic.

7. Calculate and Compare P/E Ratios Vs. Expected Earnings Growth Rates
When analysts review retail companies to determine whether they are "cheap," they typically calculate the current price-to-earnings ratio (P/E) of a particular company, and then compare it to the expected rate of earnings growth for that same company. Companies that trade at an earnings multiple that is less than the expected growth rate are considered to be "cheap," and may be worth a further look.

Let's look at an old example: in December 2006, Target traded at 18.31 times its fiscal 2007 earnings estimates. This was at a premium to its expected 13% earnings growth rate in the coming year (from $3.18 to $3.59 per share). Using this method of evaluation, analysts would probably not think that Target's stock is very cheap. However, at the same time, Sears Holdings traded at about 20.4 times its fiscal 2007 earnings estimates. That is at a slight discount to its anticipated 23% earnings growth over the next year (from $8.45 to $10.37 per share). Using this data point alone, Sears would have been considered the "cheaper" stock.

With that in mind, investors should be cautioned that this is just one metric. It should go without saying that same-store-sales numbers, inventory trends and margins (in addition to a number of other factors) should also be considered when selecting a retail stock for investment.

8. Tabulate Tangible Book Value
A company's tangible book value per share will reveal what its assets are really worth, and what the investor is really getting for his or her money.

To determine this number, investors should take the total "stockholder equity" number from the company's balance sheet and then subtract any intangibles such as goodwill, licenses, brand recognition, or other assets that can't be readily defined or valued. The resulting number should then be divided by the total number of outstanding shares. Companies that are trading at or near tangible book value per share are considered to be a good value.

For example:

Let's say that a company has $20 million in shareholder's equity, and goodwill and brand recognition worth $2 million each. With two million shares outstanding, the tangible book value per share would be as follows:

With all of that in mind, sometimes companies that trade at a very low multiple of tangible book value are trading that low for a reason. There might be something wrong! In any case, its worth investigating, because it will give investors a sense of what the business is truly worth (on an asset basis).

9. Examine the Geographic Footprint
If an investor is comparing two companies that are otherwise identical, the investor should select the one (for investment) with the most diversified revenue base and store locations. Why?

Consider the case of Duane Reade, which in 2010 became a subsidiary of the Walgreen Company. In 2001, Duane Reade had a huge presence in New York City. Its business, along with the local economy, was booming. Then the September 11 terrorist attacks occurred. As a result of its narrow geographic footprint, its company-wide sales took a big hit, as a number of its locations were either closed or made inaccessible by construction.

However, back then, its former rival Walgreens maintained thousands of stores in a number of states nationwide (and that also maintained stores in the New York area at the time), and was much more insulated against these regional difficulties and did not suffer the same degree of sales decline.

Put yet another way, try not to invest in companies with too much at stake in one geographic region.

The Bottom Line
To analyze retail stocks, investors need to be aware of the most common metrics used, as well as the company-specific and macroeconomic factors that can have an impact on the underlying stock prices.

Related Articles
  1. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  2. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  3. Stock Analysis

    Under Armour's Plan to Double Revenue

    Learn how Under Armour plans on doubling its revenue by 2018. Find out what areas the company plans to count on for this growth and its record streak.
  4. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  5. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  6. Taxes

    Internet Sales Tax Vs. Brick & Mortar Sales Tax

    Learn about the differences between sales taxes and Internet sales taxes, and the goods and services that typically incur each type of tax.
  7. Entrepreneurship

    How an Internet Sales Tax Will Affect Your Small Business

    Learn about how the Marketplace Fairness Act may impact small business owners should it pass in the House and what the act requires from business owners.
  8. Savings

    Craft Beer Clubs – Bargain or Not?

    If you're an aficionado of artisanal brews (or would like to be), a beer club can be a palate-pleasing, albeit pricey, way to expand your hops horizon.
  9. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  10. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  1. What are the main reasons for investing in the retail sector?

    The retail sector is diverse, dynamic and extremely susceptible to changing consumer tastes, yet the industry seems to grow ... Read Full Answer >>
  2. Does QVC accept debit cards?

    QVC accepts debit card payments as one of its many payment options. The company, which is the world’s leading video and e-commerce ... Read Full Answer >>
  3. Does QVC charge sales tax?

    QVC, an American TV network, is registered with states to collect sales or use tax on taxable items. QVC is also required ... Read Full Answer >>
  4. Can you pay off a Walmart credit card in store?

    Wal-Mart Stores, Inc. (NYSE: WMT) allows multiple payment options for its credit cards, including in-store payments. The ... Read Full Answer >>
  5. Does Walmart take international credit cards?

    Foreign visitors to Walmart locations in the United States can use their credit cards issued by banks outside of the U.S. ... Read Full Answer >>
  6. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center