Three Ways to Score With Retail, Restaurant Stocks

Last time, I ran down 10 key metrics in the retail and restaurant industries. Now, with the holiday shopping season upon us, let's put some of those metrics and other investment skills to work. This installment of The Finance Professor will explain three effective ways to research a specific retailer or restaurant.

1. Don't Be Fooled by Same-Store Sales -- Gross Margins Matter Too

Same-store sales are so widely promoted that the emphasis on this metric has sprung up a cottage industry of hyper-focused data providers and analysts. Thomson Financial has one such product, but I do not use any of these third-party retail research products. I contend that same-store sales can be a misleading metric and that gross margins need to be factored in as well.

Why? Here's an example:

• Company A operates a store with a single location (open for at least 13 months). Last year, in October, that store sold $1,000 of merchandise, whereas in October of this year, the store sold $1,200 worth of goods. This would imply a positive 20% same-store sales comparison.
• Company B operates a store with a single location (open for at least 13 months). Last year, in October, that store sold $1,000 of merchandise, whereas in October of this year, the store sold $900 worth of goods. This would imply a negative 10% same-store comparison.

So far, Company A looks like a winner, and Company B looks likes it might be experiencing problems. Now let's incorporate the concept of gross margins .

• Company A's gross profits last year were $200, for a gross margin of 20%. This year, Company A's gross profits were $150, resulting in a gross margin of 12.5%.
• Company B's gross profits last year were $200, for a gross margin of 20%. This year, Company B's gross profits were $300, resulting in a gross margin of 33.3%.

So what happened? Company A made a clear effort to boost sales but did so by discounting or selling lower-margin products. On the other hand, Company B focused on selling more profitable products without concentrating on the "top line" number. If you relied solely on same-store sales, then Company A would be appear to be the better investment. However, once you factor in gross profit margins, then Company B proves to be the more successful business.