Has Gap Become the Perfect Stock?

Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, and then decide whether Gap (NYSE: GPS  ) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • 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 mean nothing if a company can't produce profits from them. Strong margins ensure that the company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. 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

Five-year annual revenue growth > 15%

(1%)

Fail

 

One-year revenue growth > 12%

4%

Fail

Margins

Gross margin > 35%

38.1%

Pass

 

Net margin > 15%

6.6%

Fail

Balance sheet

Debt to equity < 50%

39.5%

Pass

 

Current ratio > 1.3

1.84

Pass

Opportunities

Return on equity > 15%

34.4%

Pass

Valuation

Normalized P/E < 20

16.69

Pass

Dividends

Current yield > 2%

1.4%

Fail

 

Five-year dividend growth > 10%

8.8%

Fail

       
 

Total Score

 

5 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at Gap last year, the company hasn't been able to regain the point it lost from 2010 to 2011. But the stock has positively soared, climbing 80% over the past year as the company finally engineered a long-awaited turnaround.

For years, Gap languished in the retail space. Up-and-comers Abercrombie & Fitch (NYSE: ANF  ) and Aeropostale (NYSE: ARO  ) made big inroads into the industry, leaving Gap feeling middle-aged and unable to restore the former glory of its youth. High cotton costs, low margins, and a promotion-heavy retail environment made it difficult for Gap to make any headway.

But this year, Gap has truly gotten its groove back. Moving away from a geographically based management system, Gap has turned toward brand-based management that presents a more unified approach and creates a uniform experience for customers.

Gap is also pushing toward higher-margin business. Its Athleta line is a direct attack on lululemon athletica (Nasdaq: LULU  ) , which has enjoyed unparalleled success with its line of yoga and fitness clothes. With Nike (NYSE: NKE  ) and Under Armour (NYSE: UA  ) having shown big gains as the athletic apparel business generally gets healthier, Gap looks like it may be in the right place at the right time.

For Gap to improve, though, it needs to turn recent gains into lasting competitive advantages. In the fickle world of fashion, that's a tall order for any company. But with a long history of past success, Gap has what it takes to deliver an encore performance.

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

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the "3 Companies Ready to Rule Retail" in our special report. Uncovering these top picks is free today; just click here to read more.

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


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