Bed Bath & Beyond Is a Better Business than Wal-Mart and Target

What factors make a great business? Most individuals, if asked such a question, would likely rattle off a list of characteristics like revenue growth, net income, number of locations, and stock performance. While all of these factors are important to consider before investing, the most important factor is, ultimately, how much money a business can earn on the capital invested by its owners. This metric, also known as return on equity, is extremely important to long-term investors, and is almost always a sure-fire way to determine which business truly is the best. For this reason, many investors will be surprised to learn that one of the best retailers in terms of return on equity is not one of the names synonymous with retail, like Wal-Mart Stores (WMT -0.08%) and Target (TGT 0.18%), but rather a smaller competitor in the home goods space -- Bed Bath & Beyond (BBBY).

A true specialist in home goods
What separates Wal-Mart and Target from Bed Bath & Beyond is the fact that Bed Bath & Beyond specializes in home goods, offering a wide variety of styles, colors, and textures, whereas Wal-Mart and Target provide a large, basic assortment of merchandise and food products, neither company specializing in home goods. Surprisingly, Bed Bath & Beyond is catching up to Target in terms of store count, while Wal-Mart still trumps them both with 11,096 stores throughout 27 countries as of November 2013. Nevertheless, in the third quarter of fiscal 2013, Bed Bath & Beyond reported the best same-store sales growth, despite having fewer stores and earning less revenue and net income, as seen below.

Giving back to shareholders
Since Bed Bath & Beyond, Target, and Wal-Mart compete within the retail industry, each company's profitability can be compared against the others to determine which retailer operates a better business. You would assume that a large company like Wal-Mart, operating thousands of stores and generating billions in revenue, would provide a greater return in terms of profit to its owners, but this isn't always the case. In fact, over the past three fiscal years, Bed Bath & Beyond has generated an average return on equity of 25.36%, whereas Target and Wal-Mart generated less of a return on equity, coming in at 17.16% and 21.53%, respectively. This demonstrates that Bed Bath & Beyond shareholders have been receiving back one-quarter of what they have invested every single year. The same cannot be said for Target and Wal-Mart shareholders. However, an even more shocking realization is made clear when examining the balance sheets of these companies.

Use of debt in affecting return on equity
As with any company, return on equity can be improved by borrowing money and investing proceeds in operations. The only cost in doing so is that a company must pay interest on that debt. The interest paid on long-term debt is generally preferable to issuing more stock. The alternative, issuing new shares, effectively decreases current shareholders' ownership percentage and is, thus, usually frowned upon. American corporations can, and often do, increase return on equity by issuing long-term debt. While this makes sense from an economic perspective, it distorts the picture painted by return on equity comparisons. This is why it is important that investors take into account the leverage assumed by a company when evaluating fundamental returns. Such comparisons between Wal-Mart, Target, and Bed Bath & Beyond yield a stunning result:

Not only does Bed Bath & Beyond possess the highest return on equity, but it does so without any long-term debt. Target and Wal-Mart, on the other hand, have issued billions of dollars in long-term debt, while Bed Bath & Beyond has shied away from leverage, instead focusing on running a solid operation. Based on these facts, Bed Bath & Beyond clearly runs the strongest business, compared to Wal-Mart and Target.

Foolish takeaway
Finding great businesses with strong returns on invested capital is one of the most Foolish things an investor can do. While all businesses have flaws, it should be clear based on this information that Bed Bath & Beyond is worthy of a closer look by Foolish investors seeking a great business with great returns and little to no debt.