Should Weakness in American Eagle Outfitters, Inc.'s (NYSE:AEO) Stock Be Seen As A Sign That Market Will Correct The Share Price Given Decent Financials?
American Eagle Outfitters (NYSE:AEO) has had a rough three months with its share price down 29%. But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Specifically, we decided to study American Eagle Outfitters' ROE in this article.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
See our latest analysis for American Eagle Outfitters
How Do You Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for American Eagle Outfitters is:
26% = US$356m ÷ US$1.4b (Based on the trailing twelve months to April 2022).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.26 in profit.
Why Is ROE Important For Earnings Growth?
So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.
American Eagle Outfitters' Earnings Growth And 26% ROE
First thing first, we like that American Eagle Outfitters has an impressive ROE. Additionally, a comparison with the average industry ROE of 32% also portrays the company's ROE in a good light. Needless to say, we are quite surprised to see that American Eagle Outfitters' net income shrunk at a rate of 2.0% over the past five years in spite of its decent. We reckon that there could be some other factors at play here that are preventing the company's growth. For example, it could be that the company has a high payout ratio or the business has allocated capital poorly, for instance.
However, when we compared American Eagle Outfitters' growth with the industry we found that while the company's earnings have been shrinking, the industry has seen an earnings growth of 31% in the same period. This is quite worrisome.
Earnings growth is a huge factor in stock valuation. It’s important for an investor to know whether the market has priced in the company's expected earnings growth (or decline). Doing so will help them establish if the stock's future looks promising or ominous. Is AEO fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is American Eagle Outfitters Making Efficient Use Of Its Profits?
American Eagle Outfitters' low three-year median payout ratio of 22% (or a retention ratio of 78%) over the last three years should mean that the company is retaining most of its earnings to fuel its growth but the company's earnings have actually shrunk. This typically shouldn't be the case when a company is retaining most of its earnings. So there could be some other explanations in that regard. For example, the company's business may be deteriorating.
In addition, American Eagle Outfitters has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 39% over the next three years. Therefore, the expected rise in the payout ratio explains why the company's ROE is expected to decline to 19% over the same period.
Summary
On the whole, we do feel that American Eagle Outfitters has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Having said that, looking at current analyst estimates, we found that the company's earnings growth rate is expected to see a huge improvement. To know more about the latest analysts predictions for the company, check out this visualization of analyst forecasts for the company.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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