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American Eagle Outfitters, Inc.'s (NYSE:AEO) Stock Has Seen Strong Momentum: Does That Call For Deeper Study Of Its Financial Prospects?

American Eagle Outfitters (NYSE:AEO) has had a great run on the share market with its stock up by a significant 17% over the last three months. Given that stock prices are usually aligned with a company's financial performance in the long-term, we decided to study its financial indicators more closely to see if they had a hand to play in the recent price move. Particularly, we will be paying attention to American Eagle Outfitters' ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for American Eagle Outfitters

How Do You Calculate Return On Equity?

The formula for return on equity is:

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Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for American Eagle Outfitters is:

12% = US$143m ÷ US$1.2b (Based on the trailing twelve months to May 2021).

The 'return' is the profit over the last twelve months. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.12.

Why Is ROE Important For Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. Generally speaking, other things being equal, firms with a high return on equity and profit retention, have a higher growth rate than firms that don’t share these attributes.

American Eagle Outfitters' Earnings Growth And 12% ROE

To begin with, American Eagle Outfitters seems to have a respectable ROE. Yet, the fact that the company's ROE is lower than the industry average of 24% does temper our expectations. Further research shows that American Eagle Outfitters' net income has shrunk at a rate of 30% over the last five years. Not to forget, the company does have a high ROE to begin with, just that it is lower than the industry average. Therefore, the shrinking earnings could be the result of other factors. These include low earnings retention or poor allocation of capital.

So, as a next step, we compared American Eagle Outfitters' performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 8.0% in the same period.

past-earnings-growth
past-earnings-growth

Earnings growth is a huge factor in stock valuation. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. Doing so will help them establish if the stock's future looks promising or ominous. What is AEO worth today? The intrinsic value infographic in our free research report helps visualize whether AEO is currently mispriced by the market.

Is American Eagle Outfitters Making Efficient Use Of Its Profits?

Looking at its three-year median payout ratio of 36% (or a retention ratio of 64%) which is pretty normal, American Eagle Outfitters' declining earnings is rather baffling as one would expect to see a fair bit of growth when a company is retaining a good portion of its profits. It looks like there might be some other reasons to explain the lack in that respect. For example, the business could be in decline.

Moreover, American Eagle Outfitters has been paying dividends for at least ten years or more suggesting that management must have perceived that the shareholders prefer dividends over earnings growth. Existing analyst estimates suggest that the company's future payout ratio is expected to drop to 24% over the next three years. Accordingly, the expected drop in the payout ratio explains the expected increase in the company's ROE to 36%, over the same period.

Summary

Overall, we feel that American Eagle Outfitters certainly does have some positive factors to consider. Yet, the low earnings growth is a bit concerning, especially given that the company has a respectable rate of return and is reinvesting a huge portion of its profits. By the looks of it, there could be some other factors, not necessarily in control of the business, that's preventing growth. That being so, the latest industry analyst forecasts show that the analysts are expecting to see a huge improvement in the company's earnings growth rate. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.

This article by Simply Wall St is general in nature. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.