Discount retailers have been on a tear since the beginning of the Great Recession. Once looked upon with disdain, companies like Dollar General, Family Dollar, and Dollar Tree
1. Revenue growth
The first variable to consider when gauging the quality of a retail stock, or most any stock for that matter, is sales or revenue. You'll find this figure at the very top of a company's income statement. What you want to see is a revenue figure that grows with time. And the best type of growth is organic growth -- that is, expansion from productivity at existing stores, as opposed to expansion from the construction of new locations. In the industry, the former is referred to as "same store" or "comp" sales.
As the preceding figure illustrates, Dollar Tree performs well in terms of growth on both fronts. Since 2007, its top-line sales have grown an astounding 56%, going from $4.2 billion in 2007 to $6.6 billion in 2011. This equated to an average annual increase of 10.8%. And much of this growth has occurred organically, as its average same-store sales increase continues to tick upward.
2. Margin expansion
The second variable to consider when assessing a retail stock is margin. As you probably know by now, there are three types of margin. The first one that we come across on a retailer's income statement is the gross margin. This represents the percentage of revenue remaining after the cost of goods sold are deducted. The second type of margin is the operating margin. This represents the smaller percentage of revenue remaining after operating expenses such as marketing and administrative salaries are deducted as well. And finally, the net or profit margin is the percentage of revenue that remains after all expenses, both cash and noncash such as depreciation, are subtracted from sales or revenue.
Although it's tempting to simply compare one retailer's margins to another's, doing so can produce misleading results if you're not careful to account for other factors. On the face of it, for instance, the struggling bookseller Barnes & Noble's 24.93% gross margin looks demonstrably better than the expanding giant Costco's at 12.47%. Yet nobody in their right mind would suggest that the former is a better investment candidate than the latter. While this is obvious as you proceed down their respective income statements -- as Barnes & Noble consistently loses money year over year whereas Costco makes money -- it's inherently a function of their business models. Namely, Costco is a wholesale discount retailer, whereas Barnes & Noble is not. To avoid making this mistake, you need to consider a specific company's margins over time -- look for dynamic growth, otherwise known as margin expansion, and not just a static value.
Dollar Tree similarly performs well in terms of margin expansion. As you can see in the figure above, the discount retailer has increased all three of its margin figures over the last five years. While its gross margin went from 34.4% in 2007 to 35.9% last year, the most impressive increases were in its operating and profit margins. The former increased by 4 percentage points over the period, whereas the latter increased by 2.7 percentage points.
The third variable to consider when assessing a retail stock is value. And the most accessible metric to gauge value is the price to earnings ratio, or P/E ratio, which effectively tells you how much you have to pay for each dollar of a company's earnings. Because Wal-Mart's P/E ratio is 12.99, for instance, new investors are effectively paying $12.99 for the right to each dollar of the retail giant's earnings. A good benchmark in this regard is an estimate of the broader market's P/E ratio, which currently stands at 15.87. Speaking very generally, then, anything above that would be considered relatively expensive and anything below that relatively cheap.
Another way to think about value is to invert the P/E ratio. This gives you the earnings yield, which facilitates a rough comparison to both bond yields and inflation. The risk-free rate of return right now, as measured by the yield on the 10-year Treasury bond, is 1.91%. And the current rate of inflation is 2.93%. As a result, in the absence of future earnings growth, a stock with an earnings yield below either of these benchmarks will likely underperform the market, all else equal. To return to our Wal-Mart comparison, its earnings yield is 7.8%, well above both of these valuation benchmarks.
Source: Yahoo! Finance, Wall Street Journal.
Unfortunately, as a likely consequence of its aforementioned success, shares in Dollar Tree are trading well above the broader market in terms of valuation. Indeed, while it takes $12.87 to buy $1 of the S&P 500's earnings, it takes nearly double that, or $21.85, to buy $1 of Dollar Tree's earnings. To justify this, the discount retailer will have to grow its earnings at roughly twice the rate of the broader market over the foreseeable future -- a tough task to be certain.
Foolish bottom line
At the end of the day, it's easy to understand why Dollar Tree's shares have performed so admirably over the last few years, as both its sales and margins have expanded impressively. This past success, however, cuts both ways, as its shares now trade in anticipation of like growth in the future.
While the discount retailer may be able to meet these expectations, there's no reason to gamble when you could just as soon pick up the stock identified in our recently released free report "The Motley Fools Top Stock for 2012." To access your copy of this report before the market catches on and sends this stock soaring to new heights, click here now -- it's free.
Fool contributor John Maxfield does not have a financial position in any company mentioned above. 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.