NEW YORK (TheStreet) -- Retail stocks can be very enticing due to how undervalued the shares can appear. As an example, Sears (SHLD) now has a price-to-sales ratio of around 0.12. That means that every dollar of sales is discounted by almost 80% in the stock price.
Here are three ways for investors to tell the difference between a value trap and a value play for retail stocks.
A value trap is when financials such as the price-to-sales ratio and price-to-book appear to be so compelling that investors buy and "catch a falling knife," losing money in the end. Value plays are what made Warren Buffett rich: assets in which the market is inefficiently pricing so the cost is below its intrinsic worth. That can be for a variety of factors that could range from the sector being out of favor to the chief executive mismanaging the company to bad news temporarily driving the price down.
When the price-to-sales ratio and price-to-book ratio appear low, it's bullish if sales growth and earnings-per-share growth are improving with the company making money. That is the present case with Sony (SNE). (It is not the case with Sears, J.C. Penney (JCP) and Bon-Ton Stores (BONT).) The companies bought merchandise that is not selling so it appears to be worth more than it is due to accounting, creating a value trap.
That brings up the cash conversion cycle.
This is a critical indicator for a retail company as it measures in days how long it takes for inventory to sell. For a well-run company, it will be short. That will show that management knows what the consumer wants. Wal-Mart (WMT) has a cash conversion cycle of 90.1 days. For Sears, it is 105 days, almost 20% worse. The cash conversion cycle for Bon-Ton Stores is 111 days. J.C. Penney has a cash conversion cycle of 130 days, taking nearly 50% longer to move its products than Wal-Mart.
The return-on-equity and debt, taken together, should be in line with others in the sector that are well-managed.
These are valuable indicators. The return-on-equity demonstrates how much profit the company is making off what it owns. Debt is reveals how well it is able to finance the enterprise without borrowing money. Together, these show how efficiently and how effectively the business is operating.
Warren Buffett likes to see a return-on-equity of 20%. Wal-Mart has a return-on-equity of 23.60%. Wal-Mart has a debt-to-equity ratio of 0.84. (Hence, 84 cents required to produce every dollar of equity for Wal-Mart.)
For Sears, the return-on-equity is a negative 62.90% and the debt-to-equity ratio is 2.54. J.C. Penney has a return-on-equity of a negative 71.80% with a debt-to-equity ratio of 2.12. The return-on-equity for Bon-Ton is 13.60% with a debt-to-equity ratio of 20.30.
While a picture may be worth a 1,000 words, the price is the only number that matters when it comes time to buy or sell a stock.
For Sears, Bon-Ton, and J.C. Penney, a very ugly portrait has been composed. All are down around 10% for the last month of market action, and off for the week, too. With the level of debt that each has combined the grim sales and earnings performance, it is no wonder the return-on-equity is so poor for all. That is why these collapsing retail stores are not value plays, but "pathetic" value traps that investors should avoid.
At the time of publication the author had no position in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.