In Part 1 of this two-part series, we covered the P/E ratio; a widely used valuation tool that is somewhat limited when it comes to retail stocks. In Part 2 we'll cover the other valuation tools that beginning investors should know, and discuss how useful they are for valuing retail stocks.
Factoring in growth
While the P/E ratio is useful, it only tells us how cheap a stock is relative to last year's earnings. In retail, which is subject to the changing whims of consumers, last year's results may not tell us much. One obvious solution to this problem is to factor growth into the equation.
The simplest way to do this is via the "Forward P/E," which is a P/E that uses projected earnings over the next 12 months (rather than the previous year's net income). Most investment sites will list the Forward P/E on a stocks ticker page; it is calculated by dividing a stock's price by its projected EPS.
Another popular valuation tool that factors in growth is the Price to Earnings Growth ratio or PEG ratio. The PEG made popular by legendary investor Peter Lynch, factors a stock's expected growth rate. Typically it is calculated by dividing a stock's P/E ratio by its projected growth rate, over the next year (though occasionally a five-year projection is used).
With PEG, a high P/E stock can be cheaper than a low one. If a stock has a P/E of 20, with a 20% growth rate, that stock would have a PEG of 1. Another stock trading at a P/E of 10, with a 5% growth rate, would have a PEG of 2. Therefore, the stock with the lower P/E (10) would be more expensive.
While PEG and Forward P/E both factor in growth, they are also both problematic. Both rely on analyst consensus estimates of earnings and future growth rates, which are often inaccurate and full of biases based on past performance. So use them as a guide, not a fail safe, and consider the growth projections a loose range, rather than a guarantee.
The P/S ratio
One final basic valuation tool is the Price to Sales Ratio, or the P/S ratio. The P/S, like the P/E, does not take growth into account, but it is still a valuable tool for retail stocks. The P/S ratio measures a stock's valuation by its top line revenue and not earnings. To get a companies P/S, divide its stock price by its sales over the trailing twelve months (TTM) period. Like most valuation tools, the lower the number is, the better.
Proponents of the P/S like the fact that it excludes earnings, which can fluctuate due to one-time charges and are easier to manipulate than sales. The P/S ratio may also be more useful in retail than in other sectors, particularly for retail growth stocks.
For example, take a look at Amazon. The online retailer has purposefully sacrificed its earnings in recent years, by slashing its prices investing heavily in its business, to steal market share from a wide range of competitors. Amazon is still in growth mode, so it values market share over earnings. Given this fact, Amazon has looked much pricier by its P/E than its P/S.
One popular valuation tool that has been omitted from this series is book value. Book value, made famous by Ben Graham, the father of value investing, is the value of a businesses assets. The popular Price to Book ratio divides a stock price by its book value. Like the P/E, PEG, and P/S, the lower the number is, the better.
But book value and the P/B ratio have limited use when it comes to retail stocks, for a number of reasons.
- Not all retailers carry tangible assets, such as cranes and real estate. While these "assets" may appear to be more valuable than intangible assets on a balance sheet, they are often a huge burden. Netflix, for example, was able to put Blockbuster out of business because it didn't have the overhead costs of Blockbuster's store "assets." The stores, as it turned out, were a liability disguised as an asset. Til the near end, Blockbuster looked much more attractive on a book value basis than Netflix.
- Some retail businesses like Nike carry their value in their brand. A powerful brand is not measured in tangible book value, and it's hard to value in general, but Nike's brand is much more valuable than any of its tangible assets.
With that in mind, you may want to skip book value in your analysis of retail stocks. The other tools we've discussed are pieces of a complex valuation puzzle; none of them is completely accurate, and you may end up using all of them, or more complex tools, in your analysis. Valuation, like all things investing, is equal parts art and science. The fundamentals will point you in the right direction, but ultimately you'll have to make the call on what is (or isn't) a fair price for a stock.