Ross Stores (NASDAQ:ROST) and TJX Companies (NYSE:TJX), both look more expensive than fellow retailer, Kohl's (NYSE:KSS)at first glance, but they're not. Understanding why this is true will not only lead you to two stock picks, it may also make you a better value investor.
Let me explain.
Go Beyond Traditional Valuation Tools
Ross Stores and TJX Companies have higher P/E's, of 17 and 19 respectively, than Kohl's, at 13. So how are they cheaper? The simple answer is that a low price (or multiple) only explains what you are paying. Price is what you pay, value is what you get.
Every investor has bought a stock because it seems "so cheap," only to watch it get cheaper, and cheaper. Moving your focus away from price can help you avoid that trap.
I first started looking outside traditional valuation tools (P/E, book value, etc.) when I was introduced to Joel Greenblatt's "magic formula" investing approach. This is a great way for newer investors to understand, in simple terms, why the quality of a business matters in valuation.
This approach looks for stocks with the best combination of a low earnings yield and a high return on capital. Top rated magic formula stocks may not have the lowest earnings yield (or "P/E") but they have a relatively low one, when you consider their returns on capital.
So while Ross Stores and TJX may not seem as cheap as Kohl's on a price-to earnings basis, their returns on capital are about 30% higher! In addition, as the chart below shows, this advantage has been enjoyed for years and now it is actually expanding.
You simply shouldn't perform valuations on an absolute basis; value is always relative to the underlying business. Both Ross and TJX have returns of capital of 40%, that means, for every dollar invested in the business, forty cents will be earned on an annual basis. That is simply phenomenal. To add additional perspective, for every dollar you invest in Kohl's, you get just ten cents. Since you get more with Ross Stores and TJX, they're worth more. Plain and simple.
When you consider the returns on capital, they are trading at a drastically cheaper valuation than Kohl's.
While the investing world may want to separate all investing philosophies into a "growth" or "value" camp, they actually both feed off of each other. Some of the best investors of all-time, like Peter Lynch, made a killing by using growth as part of a (relative) stock valuation.
Ross Stores most recent quarterly results showed a 7% increase in earnings, year over year, and a 6% jump in sales. TJX Companies sales rose 5% in its latest showing, and net income barely budged at all. These results may not seem stellar, but they easily best Kohl's and most traditional retail department stores.
Just look at these figures (below) of net income per employee; Kohl's is the clear laggard. This statistic measures net income growth relative to retailers largest overhead expense (employees). Stats like these are increasingly important for traditional retailers due to e-commerce competition; Kohl's is trending poorly.
And now, Ross and TJX are growing sales faster than Kohl's as well (below).
There's no reason that this trend shouldn't continue. Ross, TJX, and Kohl's compete for similar customers, folks who want something now and who want it cheap. The difference is that Ross and TJX are "off-priced" retailers, they will always give you an advantage on price (and name brands), your shirt just may not be from this season.
Kohl's meanwhile is one of a few department store retailers I feel is really in a "no-man's land," it's not high-end, but it's not cheap, so what is it? For example, if you want to buy a men's polo-shirt from Kohl's, you'll find brands like "Mark Anthony" and "Wolverine," you don't really have a chance at scoring a deal on a high-end brand. That's a scary mix of poor selection, at poor prices, and I don't know if it is sustainable in tomorrow's retail environment.
Whether you're using Joel Greenblatt's "magic formula" or using Peter Lynch's philosophy of considering growth as part of your valuation, the idea is the same. Valuing a stock simply on a price-to-earnings, or price-to-book, basis is the equivalent of looking at a 2D image. You're getting one side of the argument--how cheap the stock is today.
We all know that the stock market looks to the future. In the example used, we see that Ross Stores and TJX are earning higher returns on capital, and growing faster, than Kohl's. That's not an aberration. They both have more to offer customers, and the numbers show that. So, if you buy a 2D stock today, you may not see that its business is in decline, and it may get a lot more "expensive" tomorrow.
I recommend you consider the quality of the business you're buying as part of your valuation. With that in mind, I think Ross Stores and TJX Companies look pretty cheap right now.
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Adem Tahiri has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.