American Eagle Analysis

**teenvestor** Tue Feb 21, 2006 9:07 am

American Eagle Analysis
I recently finished reading How to Pick Stocks Like Warren Buffett: Profiting from the Bargain Hunting Strategies of the World's Greatest Value Investor.

The third part of the book is about analyzing comapnies like Buffet, here I will analyze a company that currently interests me, American Eagle.

Valuation

The first chapter is about valuation, mainly Discounted Cash Flows. I'll use 12% as my first five years growth, 8% for the next five years, and 3.5% terminal growth. $366 million will be my cash flow munber.

5 Years 12%

> Five Years 8%

Terminal 3.5%
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Discount Rate 11%

Year Cash Flow Discount Cash
1 $409.92 1.11 $369.30
2 $459.11 1.23 $372.62
3 $514.20 1.37 $375.98
4 $575.91 1.52 $379.37
5 $645.02 1.69 $382.79
6 $696.62 1.87 $372.44
7 $752.35 2.08 $362.37
8 $812.54 2.30 $352.58
9 $877.54 2.56 $343.05
10 $947.74 2.84 $333.78

First Ten Years $3,644.29
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Add Terminal Value $4,606.16
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Intrinsic Value (Per Share) $54

This model gives a value of $54; more than twice the current value. But the DCF is not all powerful, and sometimes ignoring is better than relying.
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Book Value
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Mr. Vick says book value is Buffet's favorite yardstick for growth. Here's American Eagles ten year book value growth numbers:

Year Book Value Growth Earnings Growth

1996$71.10--
1997$90.8027.71%230.51%
1998$151.2066.52%177.44%
1999$264.5074.93%67.65%
2000$367.7039.02%3.42%
2001$502.1036.55%12.47%
2002$577.5015.02%-15.92%
2003$643.7011.46%-32.36%
2004$963.5049.68%255.50%
2005$1,136.3017.93%27.47%

Average37.65%80.69%

American Eagle's book value growth is extraordinary. The growth was consistent, as compared to earnings growth which was powered by four main years. However there are bad ways a company can grow book value, I will examine those now.
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Issuing Shares
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Companies can easily grow book value by issuing more shares. While this grows cash, it also dilutes the value of shares. American Eagle has 15% share growth during the past ten years, compared to book value which has grown a total of 1,498%; share dilution is not a problem.
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Acquiring other Companies-
I also don't believe AEOS has been acquiring other companies to fuel growth.
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Letting Profits Sit Gathering Interest
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American Eagle has been sufficiently investing cash back into the business. Quicken estimates American Eagle has created $4.98 in market value for every dollar of retained earnings over the past five years.
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Return on Capital
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Return on capital shows the life-blood of a business. I will use Net Income / (Average Equity) + LT Debt. I will use a method described in the book to see what earnings growth is needed to sustain its current ROE.
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American Eagle's current ROE is 20%.
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Assuming Equity will grow about 21% a year American Eagle will have to grow earnings 14% a year to sustain a 21% ROC. The industry's current ROC is 15%, American Eagle is above this, but it could do better, and may have a hard time in the future maintaining a good ROC.
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Hurdle Rate-
The book says Buffet looks for a ten year hurdle rate of 15% CAGR before investing. I'll go a little further and look for 20% CAGR over 5 years.
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Over the last ten years American Eagle has had an average P/E of 19.6x, I will use this to project the future price for my hurdle rate calcualtions. I'll also assume a twelve percent earnings growth rate, and a 15% dividend payout.
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Expected 2010 price $ 54.59
>> Dividend $ 1.69
Total Dollar Amount $ 56.28
Expected 5y Return 168%
CAGR 21.79%
American Eagle passes the hurdle rate test, if it can grow earnings at a twelve percent rate for the next five years, and then trades at a P/E of ~19.6 the compound annual return should be about 22% per year - not too shabby.
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Putting Growth in Context
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Even Buffet admits estimating growth for a company, outside short periods, is not exactly a walk in the park.
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Vick suggests using Quicken's stock evaluator to judge the earnings growth necesary to justify the current stock price - inversing the DCF.
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Using a 15% discount rate the stock evaluator says American Eagle must grow its earnings only 2.3% to justify its current stock price.
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Comparing Stocks to Bonds
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Buffet won't buy stocks unless its earnings yield (e/p) is greater than an average bond yield.
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Using Morningstar's yield comparison I see American Eagle's earnings yield is almost double that of a 30-year T-Bill.

-Mike

[i]original post

**nodoodahs** Tue Feb 21, 2006 10:14 pm

A couple of things that weren't in the article kept it from being absolutely top notch. Some go with "traditional value investing" and some don't. I'll do the "value" items first.

No mention of insider buying or selling that might influence your opinion of the company.

No mention of the proxy statements, annual statements, etc. Like to look for related party transactions, is the compensation in line with competitors, pending litigation or SEC actions, yada yada. Any "buy and hold" analysis should include this treatment.

No mention of debt load, debt burden as a percent of cash flow or income, etc. Some debt is desirable(!) but the payments have to be affordable and the total not excessive compared to equity. Also, while you mentioned share dilution you didn't mention changes in debt over time, i.e. are they issuing new debt or paying old debt off?

I like looking at the tangible book growth. YMMV.

I like to look at earnings quality. YMMV.

No mention of short ratio, institutional ownership, or any other "smart money" positions that might influence your entry point.

Right now this stock is pretty near resistance at the $27-ish range. Considering it hasn't been too long since the stock fell from grace, there is a lot of overhead supply out there. You need a catalyst, either news-related or a technical sign of buying pressure that will push it over that mark. Otherwise, you need to buy closer to $20 where the support is. Unfortunately it seems to be tightly range-bound at $25 to $27, and drifting down. Relative to the index, it is definitely showing underperformance on decreasing volume.

**blast_investor** Tue Feb 21, 2006 11:09 pm

Well, this stock pick was submitted to the contest before and won a contest here before:

http://value-investing-forum.com/viewtopic.php?t=655

**teenvestor** Tue Feb 21, 2006 11:25 pm

It wasn't intended as a full write-up, it was intended as a book review of Vick's book, as mentioned at the beginning of the article.

I went thru each chapter of the book that had to do with stck research and applied the principles to American Eagle.

-Mike

**nodoodahs** Wed Feb 22, 2006 9:04 am

My bad. I misread the intent, thought it was a full writeup.

Blast, could you change my vote from "good" to "excellent" in that regards?