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Is Gap the Perfect Stock?

Everyone would love to find the perfect stock. But will you ever really find a stock that gives you everything you could possibly want?

One thing's for sure: If you don't look, you'll never find truly great investments. So let's first take a look at what you'd want to see from a perfect stock, and then decide whether Gap (NYSE: GPS  ) fits the bill.

The quest for perfection
When you're looking for great stocks, you have to do your due diligence. It's not enough to rely on a single measure, because a stock that looks great based on one factor may turn out to be horrible in other ways. The best stocks, however, excel in many different areas, which all come together to make up a very attractive picture.

Some of the most basic yet important things to look for in a stock are:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales don't mean anything if a company can't turn them into profits. Strong margins ensure a company is able to turn revenue into profit.
  • Balance sheet. Debt-laden companies have banks and bondholders competing with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Companies need to be able to turn their resources into profitable business opportunities. Return on equity helps measure how well a company is finding those opportunities.
  • Valuation. You can't afford to pay too much for even the best companies. Earnings multiples are simple, but using normalized figures gives you a sense of how valuation fits into a longer-term context.
  • Dividends. Investors are demanding tangible proof of profits, and there's nothing more tangible than getting a check every three months. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Gap.

Factor What We Want to See Actual Pass or Fail?
Growth 5-Year Annual Revenue Growth > 15% (2.3%) fail
  1-Year Revenue Growth > 12% 3.3% fail
Margins Gross Margin > 35% 40.9% pass
  Net Margin > 15% 8.3% fail
Balance Sheet Debt to Equity < 50% 0.0% pass
  Current Ratio > 1.3 2.00 pass
Opportunities Return on Equity > 15% 26.3% pass
Valuation Normalized P/E < 20 11.13 pass
Dividends Current Yield > 2% 1.97% fail
  5-Year Dividend Growth > 10% 22.4% pass
  Total Score   6 out of 10

Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.

Gap's score of 6 is pretty good. But the retailer has made several gaffes lately that highlight its ongoing challenges.

The clothing retailer's most recent problem came from an unlikely source: its logo. Gap changed its landmark blue box to a design that many criticized as amateurish. For a company ranking among the top 100 brands in the world, it was a silly mistake.

What's potentially more troubling is the company's long-term trend toward perceived obsolescence. Competitors Abercrombie & Fitch (NYSE: ANF  ) , Urban Outfitters (Nasdaq: URBN  ) , and Aeropostale (NYSE: ARO  ) have all passed Gap by in terms of estimated future growth. In other words, it looks like the retailer has fallen into its own generation gap.

Gap has a lot of things going for it, though. Its pristine balance sheet and good dividends are assets for investors, and its valuation is quite attractive. Even with its strongest growth behind it, Gap shares may be a good value play right now.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

Click here to add Gap to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. The Fool owns shares of Aeropostale. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.

Read/Post Comments (1) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 17, 2010, at 1:02 PM, kelbon wrote:

    Perhaps Gap's intention to change its logo was a silly mistake, but an illuminating one. The backlash over the new logo attested to the identity and strength of the brand, and the loyalty of their customers. The flexibility and savvy of Gap's management was demonstrated by a quick reversal on the logo redesign.

    Silly mistakes can be not only illuminating but investment opportunities too: New Coke anyone?

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