A Comparable Analysis of Big Retailers
Disclaimer: This is not investment advice, just one person’s opinion. Always complete thorough analysis on your own before investing and understand the risks associated with an investment as you could lose it all.
The focus of this article will be to show how I compare companies to potentially invest in them. I will walk you through how I begin a fundamental analysis of a company’s financials. Before we begin, I will use a lot of jargon and financial ratios, so please check out the vocabulary section at the bottom of the article for definitions.
I wanted to look at large retailers as a way to give newer traders a way to diversify from their traditionally tech heavy portfolios. I focused on Walmart, Costco, Target, BJ’s, Home Depot, Lowe’s, Best Buy, Dollar General, and Dollar Tree. These retailers have been resilient to the impacts of the virus, and its obvious why- if you need certain items you have to get them. Thus, these companies have retained a higher level of sales than other industries, and some like Amazon have increased sales. A note on Amazon specifically, I included it in this analysis since its rise has hurt many of the companies listed above. Having their financials side by side can help to understand why. Finally, I did not compare Amazon’s valuation ratios to the other retail companies, since Amazon has been helped by the virus and these companies have generally been hurt by the virus. The result is that I will not rank Amazon among these companies.
To create this analysis, I began by importing balance sheet and income statement data. I then created two tables to compare these companies: one in regard to valuation and another looking at quality. The valuation table uses trailing 12 month price to earnings ratio (p/e ratio), enterprise value (EV)/sales, and EV/EBIT. The end result of these ratios is to gauge the relative price of the companies compared to their earnings. The quality table looks at debt:equity, leverage, coverage, quick ratio, EBIT margin, return on assets (ROA), and inventory turnover. Debt:equity, leverage, and coverage attempt to look at the financial well-being of companies by analyzing their debt levels. The quick ratio looks at cash and cash-like assets relative to upcoming liabilities. EBIT margin, ROA, and inventory turnover look at how profitable and efficient these firms are.
Based on just the ratios, and keeping in mind a post-Covid world, I like Home Depot and Costco the best. Ranking these companies purely by the metrics mentioned previously, I would rank them in the following order, from best to worst: Home Depot, Costco, Walmart, Best Buy, Target, Dollar General, Dollar Tree, Lowes, and BJ’s. I like Home Depot the best for a few reasons. It has a strong 2.43% dividend yield, which is among the highest of its peers. Home Depot’s high dividend yield combined with its large share repurchase program, show Home Depot truly brings shareholder value. Home Depot’s share repurchase program and its large dividend contribute to a negative shareholder’s equity account and an inflated return on assets (see vocab for a more in-depth explanation). Home Depot also has the strongest profitability of its peers, this is why the EV/Sales for Home Depot is high. It makes sense that a more profitable company would have a higher value than a less profitable company with the same revenue. Right behind Home Depot, I have Costco. Costco does have higher valuation ratios than its peers, but I believe in this case when you pay more you get more. Costco has a low amount of debt and more than enough earnings to cover its debt-servicing costs. Where Costco really stands out is with its 11.8 inventory turns. This means that Costco sold all of its inventory and had to replenish it 11.8 time last year. Having a high level of inventory turns is a very good thing because it means you hold inventory for a shorter period of time. Your cash is tied up for less time, and you are free to spend it on other revenue generating items sooner. Costco’s very high level of inventory turns means that it can have low profit margins and still be a very valuable stock.
After Costco, I have Walmart which boasts better than average valuation ratios across the board. Walmart has a solid dividend yield and strong inventory turnover. It does suffer from lower profitability and return on assets, however such a strong inventory turnover combined with its valuation ratios, Walmart really stands out to me. Next I have Best Buy. To be honest, Best Buy was quite difficult to place; if I was looking at just ratios it would be among the top, but factoring in Amazon’s rise after Covid, and that people may not want to go in-store, I have it in fourth based purely on discretionary metrics. Best Buy has the best valuation ratios across the board, its 2.71% dividend yield is nothing to scoff at either. Best Buy has very low debt and has fair efficiency as well as profitability ratios. I worry about Best Buy’s ability to fend off Amazon in a post-Covid world, and thus it cannot be higher than fourth. After Best Buy I have Target. I really like Target, and would have had it much higher if not for its inventory turnover. Inventory turnover is critical for retailers, as items sitting on the shelves (not turning over) hurt profitability. Besides this poor ratio, Target has about average all other ratios. What separates Target from Dollar General is Target’s dividend yield of 2.26% and its low price to earnings ratio.
Dollar General has many average ratios. It has low debt ratios which means it could easily fix its low quick ratio by issuing debt. Dollar General has strong profitability, however it has a very poor inventory turnover ratio of 4.4. Right after Dollar General I have Dollar Tree. No dividend, valuation ratios close to Dollar General’s, low ROA, low EBIT margin, and low inventory turnover earned it the 7th spot. In 8th I have Lowes, and I did not like how it looked. To be fair, Lowes has a very strong share repurchase program and a high dividend. The issue is that it has very similar valuation ratios to Home Depot but has much worse profitability, efficiency ratios and dividend yield. The stock I like the least is BJ’s. BJ’s has a high price to earning ratio and no dividend. BJ’s has the highest leverage and the lowest interest coverage (this is not necessarily a problem as in general BJ’s has low values, but it is worth noting). ‘What is worrisome, BJ’s has the worst profitability and the worst ROA. The one breath of fresh air is that BJ’s is able to turn inventory, but the question I would ask is “does inventory turnover come at the cost of profits?” Costco is able to turn more inventory with higher profits, and higher return on assets.
Now that we have gone through a basic fundamental analysis of large retailers, we have to put this information to work. After you do your own analysis in this industry or another, the next step is my favorite- investing based on the analysis. Again, see the disclaimer this is NOT investment advice, just my opinion, always do your own analysis. After looking at the data the most obvious trade has to do with Lowes and Home Depot. I really like Home Depot, and I really don’t like Lowes. However their valuation ratios are very similar. I often use pairs pairs trades, and I think this is a great opportunity to do so. Lowes seems relatively overvalued compared to Home Depot, in my opinion. BJ’s and Costco could be another pairs trade, however the valuation discrepancy like in Home Depot and Lowes is not so flagrant. Dollar General and Dollar Tree are also worth keeping an eye on if Dollar Tree rises much more. I’m not sure I would outright short any of these companies, these stores are quite necessary for daily life, so I expect their sales to stay strong. I would feel comfortable being long any of the top 5, and will consider it.
While using financial ratios to value and compare companies is considered “good” practice among finance professionals, it is important to remember there are limitations to ratios. There is a lot of external information that goes into the value of a company in addition to ratios. And much more can affect the future performance of a stock. As mentioned previously, ratios also do not take into account past growth, company vision, or expected growth. All of which can contribute to high valuation ratios. This analysis leaves out almost all non-ratio information, which if I were to invest in a company I would absolutely consider. Leaving this out allows for an easier demonstration of a comparable analysis of retailers.
Stay tuned for more industry analyses. And follow my Invstr page @robbieb for trading ideas and commentary on events in financial markets.
Share repurchases: A company can buy its own shares with cash on the open market. This reduces the amount of shares. Reducing shares makes earnings per share higher, and gives each shareholder more value.
Shareholder’s equity: The amount of ownership of assets a company has. (Assets-Liabilities)
Note on Home Depot’s negative share holder’s equity: When a company repurchase shares it decreases cash and decreases shareholder’s equity. When a company pays dividends it decreases cash and shareholder’s equity. Both of these actions have decreased Home Depot’s shareholder’s equity to a negative number. When there is a large amount of share repurchases, return on assets and other metrics become inflated. Using ROA as an example, when you spend cash to buy shares, your assets decrease. If your denominator (assets) decreases and earnings stay the same, you have a higher ROA.
P/E: Stock Price/Earnings per share. Measures how much you are paying for a dollar of earnings.
EBIT: Earnings before interest and taxes.
EBITDA: Earnings before interest, taxes, depreciation, and amortization.
Inventory turnover ratio (Costs of goods sold/Average inventory): Measures how many times a company replenishes their inventory per year. A higher turnover indicates items spend less time on the shelf, which is a good thing for retailers.
Enterprise value (EV): market capitalization + preferred equity + minority interest + total debt – cash
EV ratios (EV/sales, EV/EBIT, and EV/EBITDA): Measures how much a company earns relative to the total value of the firm.
Debt:equity: Ratio of how much debt financing a company uses compared to equity.
Leverage (Debt/EBITDA): Measures debt relative to earnings.
Coverage (Interest expense/EBITDA): Measures how many times a company can cover its interest expense with the most recent earnings.
Quick ratio: (link to article)
EBITDA margin (EBITDA/sales): Measure of profitability.
ROA (Net income/Average total assets): Return on assets measures how profitable a company’s assets are at producing revenue.