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Why These Department Stores Belong in Your Portfolio

Thursday - 5/23/2013, 3:51pm  ET

Dillard’s  finished 2012 up about 85% on the year by going after customers who are looking for a price point somewhere between Macy’s  and Nordstrom . It has moved upscale over the last few years and managed to distinguish itself from peers like Kohl’s and J. C. Penney.

After showing robust growth in 2012, Dillard’s has gotten off to a strong start in 2013, showing a 10.3% price increase to date, an increase of about $8.50 per share. Is Dillard’s equipped to continue its remarkable run?  Do Macy’s and Nordstrom have the potential to do the same? Let's measure these retailers by several of my favorite metrics, including the price-to-earnings-to-growth ratio, tangible book value per share, and free cash flow.

PEG Ratio

Formulaically, the PEG ratio is the price-to-earnings ratio divided by the annual earnings per share growth. It determines the relative trade-off between stock price, earnings per share, and the expected growth of the company. It can be more accurate than the price-to-earnings ratio as it corrects for a company’s rate of growth, thereby giving us a better idea of the valuation of a stock. This is particularly apropos in our analysis, since Dillard’s had such robust growth in 2012. In general, a ratio between 0 and 1 indicates an undervalued stock and a potential for higher returns, while a ratio above 1 indicates a potential for decreased returns. That being said, let’s look at how it applies to the companies under evaluation:

DDS PEG Ratio data by YCharts

As you can see, Dillard’s has a clear advantage by this metric. Its ratio is far below Macy’s and Nordstrom, even though all three are showing significant growth. From an interpretive standpoint, Dillard’s is by far the most undervalued stock, and thus has the highest potential for increased returns. Another way of thinking about it is that given the expected growth of Dillard’s its stock is radically undervalued. However, Macy’s and Nordstrom both have ratios near 1, which indicates that their stock is most likely reasonably priced given expected growth.

Tangible Book Value per Share (TBVPS)

Tangible book value per share is another way of valuing a company, this time on a per-share basis. In formal terms, it is the portion of tangible assets attributable to each share of common stock; in layman’s terms, this metric answers the question: “What would I get if this company were to go bankrupt and all assets were liquidated at book values?” This is commonly used to evaluate whether a company is undervalued or overvalued, since dividing the tangible book value per share by the share price gives a comparison of current value to tangible book value.

DDS Tangible Book Value Per Share data by YCharts

DDS data by YCharts

 

TBVPS

Price

TBVPS / Price (valuation)

Dillard’s

41.7

$92.26

.451

Nordstrom

8.686

$60.69

.143

Macy’s

4.42

$48.88

.090

Here, Dillard’s once again comes out on top. It is by far the least overvalued of the three stocks that we are considering. Macy’s is potentially drastically overvalued, as is Nordstrom. Thus, investors should exercise caution when investing in those two. With Dillard’s, though, it’s full steam ahead.

Free Cash Flow

Free cash flow, simply put, is how much cash a firm has available to distribute to security holders. It shows how much cash that firm can create, as well as indicate the firm’s potential to grow, and can be used to make acquisitions, pay off debt, etc. Generally, a strongly positive free cash flow is a good thing. However, it’s important to recognize that a negative free cash flow isn’t necessarily bad—it could mean that a company has a lot of money tied up in investments, which will eventually pay off. Because of the nature of investments and returns, it’s natural for free cash flow to fluctuate up and down from quarter to quarter. So how do our firms stack up?

DDS Free Cash Flow data by YCharts

This is the one metric where the order that we have seen gets flipped on its head. Macy’s is our winner running away. Its free cash flow is more than $500 million greater than Nordstrom, and more than $700 million greater than Dillard’s. So what’s the takeaway from this? Macy’s is in a much better position than the previous two indicators show. Like Nordstrom and Dillard’s, it has shown consistently strong growth, and part of this could be due to investments that are paying off. Macy’s free cash flow also shows much larger fluctuations than Nordstrom or Dillard’s, which implies that large investments are being made. That’s something to watch—if some of those investments go bad, Macy’s could face an uphill battle. However, its track record has shown that it can capitalize on investments, which is a very good sign for the company especially given its large free cash flow.

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