How to Value a Retail Stock: Part 1

An Overview of the P/E ratio, EPS, and Retail Valuation

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RadioShack is a prime example of why a low-priced stock is not always a good deal. Joe Raedle/Getty Images News/Getty Images

Many investors are lured toward stocks for a thrill. They've heard a story from a neighbor, friend, or co-worker, who bought Amazon.com in 1997 and rode their way to riches. While those stories do exist, few stocks have the game changing potential Amazon had in 1997. In most instances, successful investment is based largely on buying a stock at the right price. 

Ultimately, your goal should be to buy stocks the same way you would a washing machine;  conduct a fair amount of research and seek out the best value for your money.

While that may not sound exciting, value investing has been proven to be quite profitable. While there are many ways to value a stock, a few basic tools are universal. Today, we'll touch on the most universal valuation tool of all, the P/E ratio, as well as how useful it is for retail stock investing. 

Understanding EPS and the P/E

Unfortunately, a "value" stock is not simply the cheapest priced stock you can find. A $2 stock can be, and often is, much more expensive than a $200 stock. To understand why, you must first understand what earnings per share (EPS) is.

Each stock is a share, or part ownership, in a real business. What that share entitles you to, is a small percentage of a businesses profits or "earnings." By dividing a firms net income, by the number of its shares outstanding, we arrive at its EPS. Now, the company won't actually write you a check for that whole amount each quarter, though you may get a portion in the form of a dividend payment, but its earnings per share represents your cut of the profits, for each share you own.

One important thing to remember is that higher EPS does not necessarily mean higher profits, a firm may just have less shares outstanding. Here's an example: If Retailer "X" has $1B in annual net income, and issues 1B shares, its annual EPS will be $1/share. If Retailer "Z" also has $1B in annual net income, but has 2B shares outstanding, its annual EPS will be $0.50/share.

 

Earnings-per-share is the most important variable in determining a stocks value. When we combine it with valuation tools, such as the famed "P/E," we understand why a $2 stock might not be so cheap after-all.

The price-to-earnings ratio, commonly referred to as "the multiple," the "P/E," or "price-to-earnings multiple," is the most widely used valuation tool for stocks. Simply put, the P/E ratio is a multiple based on a companies current earnings that expresses what investors are willing to pay for those earnings. While a stocks"P/E" is typically displayed next to its ticker on sites like Yahoo! Finance or The Motley Fool, you can also calculate it yourself quite easily, by dividing a stocks share price by its EPS. For example, if Best Buy's share price is $80, and its EPS (TTM) is $8, its P/E ratio is 10; 80, divided by 8, is 10. 

The lower the P/E, the less you are paying for a businesses earnings. Yet, even then, a lower P/E does not always mean a cheaper stock in retail.

Limitations of the P/E with retail stocks 

The P/E is an important, though somewhat limited, valuation tool when it comes to retail stocks. For starters, the common P/E tracks a firms trailing twelve months of earnings (TTM), but it does not account for the future.

Since retail is constantly changing, with retailers falling in an out of favor rapidly, basing valuation on what happened last year can be problematic. RadioShack, for instance, turned a profit as recently as 2012, but rapidly changing consumer tastes have pushed it into bankruptcy. So when it comes to retail, what happens next is just as important as what happened last.

Second, a retail stock may also have abnormally high EPS due to a one time event or cyclical period. This could because it released a hit product, closed a bunch of locations, or received a one time favorable tax ruling. All of these factors will make the stock seem cheap by way of the P/E but, when the following years earnings fail to measure up, the P/E will jump in a hurry. 

Historically, the median P/E for all S&P stocks is around 14, but retail stocks often trade at higher multiples.

The reasons why a high P/E retail stock may be cheaper than a low P/E one have to do with growth expectations. In the next article of this series we'll discuss how growth plays a part in the P/E and why some common valuation tools don't work for retail stocks.