A Buffett-Grade Bet on Teenage Tastes

11/30/2010 2:33 pm EST

Focus: ETFS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

John Reese, editor of Validea Hot List, thinks the Oracle of Omaha would look great in the stock of a thriving teen apparel retailer.  

Aeropostale (NYSE: ARO) is a mall-based specialty retailer of casual apparel and accessories. The Company designs, markets, and sells its own brand of merchandise principally targeting the 14- to 17-year-olds.
A bedrock principle for Buffett is that his type of company has a "durable competitive advantage." While you should be easily able to explain where the company's pricing power comes from, there are certain figures that can qualify the company as having a durable competitive advantage.

Buffett likes companies to have solid earnings that are continually expanding. This allows him to accurately predict future earnings. Buffett would consider ARO's earnings predictable. In fact, EPS have increased every year. ARO's long term historical EPS growth rate is 33.6% and it is expected to grow earnings 14% per year in the future.

Buffett likes companies that are conservatively financed. ARO has no long term debt and therefore would pass this criterion.

Buffett likes companies with above average return on equity (ROE) of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for ARO over the last ten years is 32.9%, which is high enough to pass.

Buffett looks for companies that do not need to spend a ton of money on major upgrades of plant and equipment or on research and development to stay competitive. ARO's free cash flow per share of $2.78 is positive, indicating that the company is generating more cash that it is consuming.

Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett would take the total amount of retained earnings over the previous ten years of $8.05 and compare it with the gain in EPS over the same period of $2.19. ARO's management has earned shareholders a 27.2% return on retained earnings. This would be more than acceptable to Buffett.

Buffett likes to see falling shares outstanding, which indicates that the company has been repurchasing shares. ARO's shares outstanding have fallen over the past five years from 121.6 million to 95 million.

ARO currently has a book value of $5.33. If ARO can preserve its average rate of return on equity of 32.9% and continues to retain 100% of its earnings, it should be able to sustain an earnings growth rate of 32.9% and have a book value of $91.32 in ten years. If it can still earn 32.9% on equity in ten years, then expected EPS will be $30.02.

$319 a Share in Ten Years?
Now take the expected future EPS of $30.02 and multiply by the lower of the five-year average P/E ratio (13.2) or current P/E ratio, which is 10.6, and you get ARO's projected future stock price of $319.39. These numbers indicate that one could expect to make a 28% average annual return on ARO's stock at the present time. Buffett would consider this an absolutely fantastic expected return.

If you take the EPS growth of 14%, based on the analysts' consensus estimated long-term growth rate, you can project EPS in ten years to be $9.40. Now multiply by the current P/E ratio of 10.6. This equals the future stock price of $99.64. Based on this target, you could expect a 14% average annual return on your money.

Taking an average of the two methods, investors could expect an average return of 21% on ARO stock for the next ten years. Buffett would consider this a great return.

[Reese recently recommended another retailer based on a different guru’s formula; and has also favored a UK drug maker based on Buffett’s criteria. Retailers figure prominently in Jim Jubak’s suggestions for playing recent economic strength in the US. For another play on discretionary consumer spending, check out Joseph Hargett’s writeup from Monday—Editor.] 

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