Even though retail products may appear relatively easy to understand and relate to, retail companies can be difficult for the average investor to analyze properly. But, the good news is that if an investor is aware of 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.

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 by perusing the aisles of a particular retail location. Information that can be found readily includes 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 the 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? These are all questions investors should ponder 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 and see how appealing the layout is, the prices of products offered, the ease of the check-out process, and the quality of the customer service. Find third-party reviews online of how others rate the site.

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 from the consumer out of desperation or weakness (because it can't sell its wares)? This is important 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 or online ads 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. Focus on Sales-Per-Square-Foot Data

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

For example, Target Corporation's (NYSE: TGT) sales-per-square-foot was around $314 in 2018, which makes sense since Target often sells low and moderately priced goods out of enormous super-centers. On the other end of the spectrum, high-end retailer, Coach—owned by parent company Tapestry, Inc. (TPR)—reported sales-per-square-foot of around $1,224 in 2018. Using this metric, an investor could conclude that Coach's management is making better use of its floor space than its counterparts at Target. It may also suggest that Target has a more diverse merchandise mix and may have more flexibility concerning 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 (AR). 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. This latter option 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 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 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 some 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 ratio) 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 might be worth 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 looking. 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 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 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, Inc. (NYSE: 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 therefore much 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.