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The Reward-Risk Analysis

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By hheiserman
January 16, 2008

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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.


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.