3 Ways to Spot a High-Quality Stock

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It's easy to get weighed down by the number and complexity of investing statistics, from Groupon's adjusted "consolidated segment operating income" to my personal favorite, the "modified butterfly spread." Fortunately, when it comes to retail stocks, you can focus on three simple statistics to make good buying and selling decisions.

1. Same-store sales
Same-store sales reveal whether a retail company is improving its existing operations. This metric compares sales from identical outlets to identical periods in the past, most often annually, allowing you to factor out any revenue growth coming from new stores.

Increases between 10% and 20% are great by any measure. The only company in the accompanying table to achieve that feat regularly over the past year was lululemon athletica (NAS: LULU) , a self-described upscale yoga-inspired apparel company.

Increases between 1% and 10% are the norm. Appropriately, the majority of companies in the table reported sales in this category in most quarters.

And same-store sales that are either flat or negative are bad. The two companies to fall into this category in most preceding quarters were Best Buy (NYS: BBY) and Barnes & Noble (NYS: BKS) .

Same-store sales, last four quarters

Company

Latest quarter

Q-1

Q-2

Q-3

Lululemon16%28%29%31%
Costco (NAS: COST) 12%7%7%6%
Nordstrom (NYS: JWN) 6.5%7.3%7.8%6.7%
Target (NYS: TGT) 2%2.4%1.6%1.7%
Best Buy(1.7%)(4.6%)(3.3%)(.1%)
Barnes & Noble(2.9%)7.3%(3.3%)(.9%)

Source: Quarterly press releases.

2. Gross margin
Gross margin indicates both potential profitability and brand power. It's the amount of each dollar a company has left after paying its sales costs -- including the cost of the goods themselves.

A company's gross margin is a function of its business model. As seen in the table below, discounters like Costco and Wal-Mart have low gross margins, but compensate with higher sales volumes. Higher-end companies like Lululemon, on the other hand, maintain high gross margins, but sell fewer units.

You'll want to avoid companies that post sustained decreases in gross margin over time. Barnes & Noble provides one such example, reporting a decline in its gross margin from 30.3% in 2007 to 25.6% in 2010.

Gross margins, 2007-2011

Company

2010

2009

2008

2007

Lululemon55.49%49.26%50.66%53.26%
Nordstrom39.21%38.24%36.81%37.40%
Target30.87%30.26%29.53%32.56%
Barnes & Noble25.62%28.86%30.87%30.32%
Best Buy25.14%24.47%24.43%23.85%
Costco12.77%12.72%12.39%12.35%

Source: Quarterly press releases.

3. Free cash flow
The final metric is free cash flow -- the difference between the cash leaving a company for regular expenses and capital expenditures, and the cash coming in from sales. Like gross margin, the trend over time is more instructive than the specific number at any one point.

Lululemon and Costco provide textbook examples, each growing their respective free cash flows from 2007 to 2010. Barnes & Noble and Best Buy offer the counterpoint, reporting decreased free cash flows over the same period.

Free cash flow, 2007-2011

Company

2010

2009

2008

2007

Lululemon$150$102$6$7
Nordstrom$778$891$285($189)
Target$3,142$4,152$883($244)
Barnes & Noble$89$3($681)$240
Best Buy$446$1,591$574$1,228
Costco$1,725$842$607$701

Source: Capital IQ, a division of Standard & Poor's. Numbers in millions.

Always do your homework
At the end of the day, although it isn't difficult to identify great retail companies using these three metrics, it's important to do your homework before investing in one. Coming to grips with these statistics is an important step toward becoming a great investor. To help you along this journey, download our free report, "The Motley Fool's Top Stock for 2011."

At the time this article was published Fool contributor John Maxfield does not own shares in any of the companies mentioned in this article. The Motley Fool owns shares of Costco, Wal-Mart, Lululemon Athletica, and Best Buy.Motley Fool newsletter serviceshave recommended buying shares of Wal-Mart, Costco, Lululemon Athletica, and Best Buy.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Wal-Mart. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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