AEO Is Almost Attractive

Moving down the income statement, SG&A for the last four quarters is $715 million. If times are tough we'll assume overhead is cut 5%, resulting in a projected selling, general and administrative costs line item (SG&A) of $679 million. Depreciation is another $103 million, so total fixed expenses is $782 million, EBIT is $315 million and net income is $195 million, at a 38% tax rate.

Based on 213.96 million shares outstanding, EPS is 91 cents. At 10 times earnings, the implied operating value is $9 a share. Add in $3 of net cash and you get a worst-case intrinsic value of $12. American Eagle's actual net cash per share is higher, but in a slowdown the company would incur severance costs, store closing costs, etc., which would eat into its cash balance.

Having estimated American Eagle's intrinsic value based on optimistic and pessimistic outcomes, we are now ready to calculate its reward-risk ratio. Reward is equal to the best-case intrinsic value minus the stock price, and risk is the current stock price minus the worst-case intrinsic value.

At $19, we have $23 of upside and $7 of downside, or a 3.3-to-1 ratio.

The higher the reward-risk ratio, the better your chances of doing well with a stock over the long term. I look for a score of at least 3.0, which implies $3 of reward for every $1 of risk.

If American Eagle's reward-risk ratio improves to 4.0, I will add to my existing position, provided the firm's fundamentals are intact. This implies a $15-$16 stock.

If you are able, calculate your portfolio's weighted average reward-risk ratio. Then, before buying your next stock, compare its profile to those of the companies you already own. The savvy investor buys companies that boost his or her portfolio's ratio, and discards the laggards.

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At the time of publication, Heiserman was long American Eagle Outfitters, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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