Though retail products are relatively easy to understand, retail companies can be more difficult to analyze. But the good news is, if an investor knows which retail metrics are important, the stock selection process will be easier. Below are nine tips investors should use when sizing up a retail stock.

Key Takeaways

  • While retail companies can be challenging to analyze as investment opportunities, there are several key metrics that can make the process easier.
  • Investors can visit the physical and online store locations, analyze promotional activities, examine gross margin trends, and review sales-per-square-foot data.
  • Other good metrics an investor can review include inventory/receivable trends, same-store sales, price-to-earnings ratios, and tangible book values.

1. Visit the Stores

An investor can learn a lot perusing the aisles of a retailer. The store's layout, availability and appearance of merchandise, and the prices charged can provide information about a retailer that can't be gleaned from a balance sheet. As a rule, investors should look favorably upon well-lit stores, and merchandise that is neatly displayed, timely and fashionable, and rarely discounted.

A savvy investor will also note the foot traffic. Is it crowded? Are there lines at the registers? Are shoppers buying big-ticket items in bulk or hovering around the discount racks? An investor should ponder these questions to help them determine the overall health of the company.

If the company has a strong online presence—or in some cases, only an online presence—then do the same with the company's website. "Walk" the virtual aisles. Note the appeal of the web layout, the prices, the ease of the check-out process, and the quality of customer service. Find third-party reviews online.

2. Analyze Promotional Activities

Is the company running promotions to drive foot traffic or earnings? Does it try to wring every last dollar from the consumer out of desperation because it can't sell its wares? This is important to consider. Companies that sell merchandise at deep discounts before the end of a sales season often do so at the expense of margins and earnings.

Visiting the store and examining the weekly circulars or online ads can give the investor an idea of whether the company is begging shoppers to come into the store, which can be a sign 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 with 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 register a decline in gross margins (either sequentially or year-over-year). Those companies are probably experiencing a decline in revenue or foot traffic, an increase in product costs, and/or heavy markdowns of merchandise, all of which can be detrimental to earnings growth.

4. Focus on Sales-Per-Square-Foot Data

This metric that some companies reveal in conference calls and others in their 10-K or 10-Q filings is a reliable indicator of how well management is using storage space and allocating resources. The higher the sales-per-square-foot data, the better it is for the company.

In 2019, Target (TGT) reported sales-per-square-foot of $326, which makes sense because it often sells low and moderately priced goods out of enormous super-centers. At the other end of the spectrum, Tapestry (TPR), which owns high-end retailers Coach, Kate Spade and Stuart Weitzman, reported sales-per-square-foot of about $1,445 in 2019. Using this metric, an investor could conclude that Coach is making better use of its floor space than Target. It might also suggest that Target has a more diverse merchandise mix and more margin flexibility, though other factors would need 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 (AR). If all is well, these two accounts should be growing in pace with revenue. However, if inventories are growing faster than revenue, it could indicate the company is unable to sell certain merchandise. Unfortunately, when this happens, companies are left with just two options: either sell product at a really low price point and sacrifice margins, or they write off the merchandise altogether. The latter option could adversely impact earnings.

If receivables are growing faster rate than revenue, this may indicate the company is not getting paid on a timely basis and could lead to a deceleration in sales in the future. In short, changes in the inventory and receivable accounts should be closely monitored, as they can 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 reveal how a store, or several stores, fare 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 the company's concept is working and its merchandise is fresh. Conversely, if same-store sales numbers decelerate, it may suggest a host of other problems exist, such as increased competition, poor merchandise mix, or some other factors that could be limiting foot traffic.

7. Calculate and Compare P/E Ratios vs. Expected Earnings Growth Rates

When analysts evaluate retailers, they typically calculate its current price-to-earnings ratio (P/E ratio) and compare the figure to the company's expected rate of earnings growth. Companies that trade at an earnings multiple that is less than the expected growth rate are considered "cheap" and might warrant a further look.

Let's look at an example. In August 2019, Target beat its earnings expectations for the second quarter, reporting an earnings per share of $1.82 versus an expected $1.62. Target traded at roughly 18 times its fiscal 2018 earnings estimates.

Using this method of evaluation, analysts would probably not think that Target's stock is cheap. However, many factors are likely at play, so a more thorough analysis of the company is warranted, as well as comparisons to its competitors (such as Walmart) and the industry as a whole. 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 several other factors) should 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 worth and what investors are getting for their 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:

Tangible Book Value Per Share\begin{aligned}&\text{Tangible Book Value Per Share}\\&\qquad=\ \frac{\text{Shareholders' Equity}\ -\ \text{Intangible Assets}}{\text{Shares Outstanding}}\end{aligned}Tangible Book Value Per Share

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. This is worth investigating because it will give investors a sense of what the business is truly worth (on an asset basis).

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:

$8.00/share = $20,000,000  $2,000,000  $2,000,0002,000,000 shares\$8.00/\text{share}\ =\ \frac{\$20,000,000\ -\ \$2,000,000\ -\ \$2,000,000}{2,000,000 \text{ shares}}$8.00/share = 2,000,000 shares$20,000,000  $2,000,000  $2,000,000

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 the pharmacy chain Duane Reade, which in 2010 became a subsidiary of the Walgreens Boots Alliance (WBA). In 2001, Duane Reade had a huge presence in New York City. The business, along with the local economy, was booming. Then the September 11 terrorist attacks occurred. As a result of the company's narrow geographic footprint, its company-wide sales declined. A number of its locations either closed or were made inaccessible by construction.

However, its former rival Walgreens maintained thousands of stores in many states nationwide (as well as in the New York area). It was far more insulated against these regional difficulties and did not suffer the same degree of earnings 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 impact the underlying stock prices. Looking at a variety of metrics can help investors get a better feel for the potential investment opportunity a retail stock may offer.