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Today Real Money published a column I wrote on how to assess a company's reward-risk profile. To illustrate, I used American Eagle (AEO), which I have written about before on these boards at higher prices. I still like the retailer.

I can't copy-and-paste the column verbatim per my contract with Real Money, but let me share highlights. Even if you do not own AEO, try to analyze the companies you own using this same analytical framework. Every edge helps in this market.

If you have any questions, please post on this board.


Hewitt


How to Create a Stock's Reward-Risk Profile

We create two parallel scenarios in order to estimate intrinsic value based on optimistic and pessimistic outcomes.

The first is estimating what the company is worth if everything proceeds as hoped.

For American Eagle, analysts forecast 14% annual growth for the next five years. This seems ambitious, because management just lowered fourth-quarter EPS expectations to a range of 64 cents to 65 cents, compared to 66 cents per share for the same period a year ago.

So instead, let's use 10% growth during years 1-5, followed by 5% growth in years 6-10. Terminal growth begins in year 11, at 3% a year. Assuming a 10% cost of equity, share dilution of 1% a year and adjusting for $787 million of net cash, I arrive at a best-case intrinsic value of $42. If your cost of equity is 11%, then best-case intrinsic value drops to $37. If share count stays flat and your cost of equity is 10%, then intrinsic value is $44.

Now, downside risk. This is what the company is worth if things get real bad. (Real, real bad is bankruptcy, but this is unlikely given the quality of American Eagle's balance sheet.)

We start by knocking revenue down 15%, to $2.6 billion from actual trailing 12 months figure of $3.03 billion. Let's also assume that gross margins decline to the eight-year average of 42.6%, vs. 48% for the fiscal year ended February 2007. Our gross profit forecast, therefore, is $1.1 billion, vs. actual TTM results of $1.4 billion.

Next, SG&A, which is $715 million for the last four quarters. If times are tough we'll assume overhead is cut 5%, resulting in a projected SG&A of $679 million. Add in $103 million of depreciation and you get total fixed expenses of $782 million, EBIT of $315 million ($1.1 billion - $679 million), and net income of $195 million, at a 38% tax rate. EPS is 91 cents, based on 213.96 million shares outstanding. 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 will incur severance costs, store closing costs, etc., which will eat into its cash balance.

Now we are 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 ($42-$19) and $7.00 ($19-$12) of downside, or a 3.3-to-1 ratio.

The higher the reward-risk ratio, the better your chances of doing well in the stock market over the long term. Investing, after all, is a probabilistic exercise. I look for a score of at least 3.0, which implies $3 of reward for every $1 of risk. For sketchier companies, or for companies in tough times (to wit: First Marblehead (FMD), which I liked in the low-$30s and still like in the low-teens), demand a higher ratio, perhaps 5-to-1.

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. You want to buy companies that boost your portfolio's ratio, and discard the laggards.
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Hi Hewitt,

I'm fairly new here and have a few questions about your analysis.

So instead, let's use 10% growth during years 1-5, followed by 5% growth in years 6-10. Terminal growth begins in year 11, at 3% a year. Assuming a 10% cost of equity, share dilution of 1% a year and adjusting for $787 million of net cash, I arrive at a best-case intrinsic value of $42. If your cost of equity is 11%, then best-case intrinsic value drops to $37. If share count stays flat and your cost of equity is 10%, then intrinsic value is $44.

Are the 10%, 5%, 3% growths pure guesses, or are they based on anything realistic? And what does "cost of equity" mean here? I guess I'm also not sure what your formula is for calculating intrinsic value.

These are probably pretty naive questions but I've got to start somewhere.

Thanks!
-Pedro
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Pedro -

Not naive at all.

First, my growth estimates. Management and analysts have used 14%. I think this number is high, given that retail stinks and the Martin + Osa concept isn't working (yet).

So I dialed back the growth forecast to 10% a year for the next five years, with a 50% decline beginning in year 6. Beginning in year 11, I assume 3% growth, which matches what the government says our inflation rate is (not that I believe them...the real number is closer to 10%, according to people who study this subject).

I hope AEO grows faster than these rates, but I'd rather err on the conservative side. Read David Dreman to learn how bad analysts are at forecasting, even going out just 6 months.

Second, the cost of equity. This is the return you need in order to get up off the sofa and call your broker to buy a firm's stock. (This return isn't guaranteed, of course.) My default rate is the yield of the 10-year treasury plus 500 basis points, or a minimum of 10%. The higher your cost of equity, the lower a firm's intrinsic value, and vice versa.

Speaking of Treasury yields, have you noticed how expensive the bond market is these days? The p/e ratio for the 3-month T bill is 46x, the 2-year sells for 49x earnings, and the benchmark 10-year has a p/e of 29x.

(A bond's p/e ratio is just the reciprocal of its yield. With the 2-year, its yield earlier today was 2.04%. So 1/.0204 = 49. By calculating the p/e ratios for bonds, you get a sense of whether stocks--which compete with bonds for investors' capital--offer good value or not. With the S&P 500 selling at 16x-17x earnings a few days ago, stocks give more bang for the buck than bonds.)

Folks are piling into Treasuries because they think lending money to the U.S. government is safer than owning stocks. Would you lend money to Washington? At these yields? Big mistake to own government bonds, I believe.

If I didn't fully explain anything, please let me know.


Hewitt
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Wow, great answers! Thanks for your response, Hewitt.

In other words, cost of equity is somewhat equivalent to asking "why should I invest in this company rather than just buying a T-bond?"

-Pedro
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You are welcome, Pedro.

In other words, cost of equity is somewhat equivalent to asking "why should I invest in this company rather than just buying a T-bond?"

Yes. Whenever you are thinking of becoming an owner, you want to compare your expected return to the risk-free rate, whose proxy is the U.S. Treasury (if you are a U.S. citizen). If your expected return -- your cost of equity -- isn't sufficiently adequate, then why bother becoming an owner.

If you read the various MF boards you will find that different people use different cost of equity figures.

My approach, as mentioned, is to use the yield of the 10-year Treasury and then add 500 basis points. Going back to the late-1920s, the market has demanded a 500 basis point spread margin of safety, based on the research that I have seen.

Tonight, the 10-year yields 3.58% (a good source is Bloomberg http://www.bloomberg.com/markets/rates/index.html). So my cost of equity should be 8.58%. But these low yields may not last, which is why I will bump my cost of equity up to 10%.

Books have been written about how to calculate the "correct" cost of equity. But whose to say my number is better than yours, or vice versa.

The key thing is to discount a firm's future earnings by your minimum required rate of return, and then buy at a big discount to intrinsic value. If I think a company has a chance of growing five-fold in a decade, my maximum price-intrinsic value is 65%. If the business has more of a value profile (authentic earnings power but no Earnings Power Staircase; to learn more see www.EarningsPower.com), then my maximum PIV is 50%.


Hewitt
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