Retail isn't an easy industry to be invested in right now, but it undoubtedly contains long-term winners. At least one of the following retailers should fit into that category: Wal-Mart Stores (NYSE:WMT), Target (NYSE:TGT), and/or Costco Wholesale (NASDAQ:COST). The five charts below provide important clues about how these retailers should perform down the road.
Free cash flow
It should come as no surprise that, as the biggest retailer in the world, Wal-Mart generates the most free cash flow among these three companies. This consistent -- and very large -- free cash flow generation allows for many opportunities, including new store growth, store renovations, innovations, investments in small-box stores, generous capital returns to shareholders, and more. However, notice that Target has shown the biggest increase in free cash flow generation over the past two years:
This might make you think Target is 100% absolutely headed in the right direction. After all, this free cash flow improvement will lead to increased opportunity, right? Perhaps.
Free cash flow is nice, but it won't mean much if the company is accumulating massive amounts of debt. Let's see how these three popular retailers are doing at managing debt by looking at their debt-to-equity ratios:
Surprise! Target might have the highest debt-to-equity ratio of the three, but it's still healthy and it has managed to reduce its debt lately. This is definitely a positive sign, but we're not done yet. Prior to investing in a company, you need to know more, and top-line growth should play a role in this.
A quick note here. Revenue growth often leads to the most short-term stock appreciation, which can be fun for a while, but if you're truly looking for safer long-term rewards, then you should pay more attention to net income growth. That said, it's always nice to see both.
As you will see from the chart below, Wal-Mart's revenue blows away that of Target and Costco, but bigger isn't always better. First take a look at the chart below:
Interesting, but what it doesn't show is that over the same time frame, Costco has grown its top line at a 53.46% clip while Wal-Mart and Target have grown their top lines at rates of 18.67% and 12.96%, respectively. Therefore, Costco is growing the fastest on the top line.
This means that Costco's warehouse membership platform is working out well in today's economic environment -- and possibly will in tomorrow's economic environment as well. While Costco generates revenue from merchandise sales, it relies more on annual membership fees. This is a good sign considering the loyalty shown by Costco members. But wait a second! Top-line growth means nothing without net income growth, right? If that's the case, then let's get to it.
Net income growth
Here you will find three retailers taking three very different paths, and this is where the story becomes much clearer. For one, you will see that Target is struggling on the bottom line. Unfortunately, this was taking place well before the data breach, and a lack of acceptance in Canada certainly hasn't helped. You will also notice that Wal-Mart has been slow and steady, which should make it appealing to long-term investors. That said, Costco is the real winner.
In Costco, you have a retailer that is growing its revenue and net income faster than its peers. Free cash flow is good and debt isn't a concern. But if you're a savvy investor, then you want to know Costco's effectiveness at delivering results from its investments.
Return on invested capital
A quality upper-management team will increase its return on invested capital faster than its peers. If Costco is the most impressive in this area as well, then this should be a no-brainer. Take a look:
Indeed, Costco outperformed its peers once again (barely scraping by Wal-Mart). Taken all together, what does it all mean?
Past results don't guarantee future success, but they sure do provide a good hint, which has a lot to do with the talent (or lack thereof) at the upper-management level. What we have learned here is that Costco is the most impressive retailer of the three, which should lead to the most upside potential going forward.
Wal-Mart should also be a quality option, especially for the risk averse. The company likes to take its time in order to ensure consistent results. Wal-Mart also offers a dividend yield of 2.5%, higher than that of Costco at 1.2%. Therefore, dividend investors might want to consider Wal-Mart first.
Target currently offers a dividend yield of 3.6%, but it lags its peers in almost every category. This isn't to say Target is likely to be a bad investment going forward, but it does mean that its long-term potential probably isn't as high as that of Costco and Wal-Mart.
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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Costco Wholesale. 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.