Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?
One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if American Eagle Outfitters (NYSE: AEO ) fits the bill.
The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:
- Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
- Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
- Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
- Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
- Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at American Eagle Outfitters.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||2.2%||Fail|
|1-Year Revenue Growth > 12%||13.0%||Pass|
|Margins||Gross Margin > 35%||36.3%||Pass|
|Net Margin > 15%||4.9%||Fail|
|Balance Sheet||Debt to Equity < 50%||0%||Pass|
|Current Ratio > 1.3||3.49||Pass|
|Opportunities||Return on Equity > 15%||12.8%||Fail|
|Valuation||Normalized P/E < 20||22.84||Fail|
|Dividends||Current Yield > 2%||2.0%||Pass|
|5-Year Dividend Growth > 10%||(7.5%)||Fail|
|Total Score||5 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at American Eagle Outfitters last year, the company has dropped a point. Yet the reason is a good one for existing shareholders; the stock has just about doubled in the past year, sending the company's earnings multiple much higher.
Teen fashion is a fickle business, and the ups and downs of various players in the industry look almost random at times. As recently as late last year, American Eagle was on the outside of trendy fashions, stuck looking in, having made just about no progress toward share-price appreciation since its early 2009 lows. Meanwhile, Abercrombie & Fitch (NYSE: ANF ) had had an amazing three-year run, quadrupling in value.
Yet since then, those roles have reversed. While Abercrombie has apparently lost its way, both American Eagle and Gap (NYSE: GPS ) have found long-lost fashion sense and had some true success, and their stock prices have both reflected their respective turnarounds. And although Urban Outfitters had surprisingly strong sales, Fool analyst Austin Smith discovered that the way it's treating online sales may have made its growth look stronger than it actually was.
The problem, though, is that the stock has gotten ahead of itself. By contrast, Buckle (NYSE: BKE ) , which has been a more stable presence in the industry lately, trades at just over half the earnings multiple that American Eagle fetches. Moreover, even with its bounce, American Eagle won't grow at anywhere near the pace of lululemon athletica (Nasdaq: LULU ) , even as the latter has suffered its own slowdown issues.
For American Eagle to improve, it needs to get its valuations under control. But revenue growth has been an impressive thing to see, and once shareholders get a little less euphoric, the stock could get closer to perfection in the years ahead if it keeps executing well.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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