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American Eagle Apparel Stores. Module 6: Cost of Capital & Valuation By: Nick Cecero. Two Costs Investors Worry About. What investors expect to recover are 2 costs that must be compensated for when providing capital for use in the enterprise: The time value of money.

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american eagle apparel stores

American EagleApparel Stores

Module 6: Cost of Capital & Valuation

By: Nick Cecero

two costs investors worry about
Two Costs Investors Worry About
  • What investors expect to recover are 2 costs that must be compensated for when providing capital for use in the enterprise:
  • The time value of money.
  • The compensation for taking the risk of investing in the enterprise of the operations.
  • These two costs make up the risk-adjusted discount rate.
  • Why we care about this Rate? It is because it is the rate at which investors require for investing in that asset.
assumptions
Assumptions
  • We first assume that interest rates are a good approximation of future interest rates.
  • Second, we assume that the current risk of American Eagle’s enterprise operations is a good approximation of the expected enterprise risk.
are those assumptions correct
Are Those Assumptions Correct?
  • In my opinion current interest are no indication of what future interest rates will be. The federal Reserve has just started its tapering and has shown that it may need to taper at a faster rate by adjusting its original estimate and tapering another $10 billion. This should drive up interest rates rather quickly to around 4% on the 10 year within 2-3 years time frame.
  • I think the assumption of American Eagle’s riskiness in its operations staying the same is not a fair assumption to make. The CEO of the past two year Robert Hanson has recently left and he helped them go from a negative growth rate to one of almost 12%. Now CEO’S just do not leave on their own as he has done unless there is some type of negative news coming down the pipeline concerning AEO. Also they have had a disappointing holiday season missing sales expectations.
cost of capital
Cost of Capital
  • Cost of Capital Components:
  • Debt
  • Equity
  • Just as a side note whether a particular company is funded by debt or equity shareholders does not change the level of risk related to the company and its activities.
  • We will use the Weighted Average Cost of Capital (WACC) will be used to estimate the cost of enterprise capital.
weighted average cost of capital
Weighted Average Cost Of Capital
  • Formula:

rEnt = (rD x (VD/VEnt)) + (rEq x (VEq/VEnt))

rD= After-tax cost of debt capital

VD/VEnt = The portion of enterprise value that is financed by debt holders

rEq= Cost of equity capital

VEq/VEnt = The portion of enterprise value that is financed by equity holders

aeo cost of equity capital
AEO Cost of Equity Capital

Utilizing 10.52% Premium

Historical Equity Premium Since 1926

1.15 Beta was pulled from Bloomberg.

bloomberg beta
Bloomberg Beta

R^2 is less than .70 which means that it is not correlated to the benchmarked index. This is essentially saying that the Beta may not be the most reliable.

AEO has underperformed its benchmark index by 1%.

why the 8 20 instead of the 10 52
Why The 8.20% Instead of the 10.52%
  • Had this valuation been done in the fall I would have recommended using the percentage of the market return of 10.52%. Analysts and money managers alike were very “Bullish” when it came to equities and even though some of the valuations were at all time historical levels it seemed as though stock prices kept rising making it viable to use the 10.52% in our CAPM calculation. As of today with emerging markets in turmoil, ISM data coming in less than positive, and the Fed starting to raise rates (Tapering) the market return on equities should be smaller which is why I choose to use a market return percentage of 8.20% instead of 10.52%.
is the capm sufficient enough
Is the CAPM Sufficient Enough
  • In my opinion for the case of American Eagle I believe that the Capital Asset Pricing Model should be estimated utilizing a multi-factor model because of two risks factors which are internal and external factors effecting their enterprise operations.
  • One internal factor that is going to have a substantial impact on their enterprise as mentioned before is that their CEO had abruptly left.
  • One external factor effecting their enterprise operations is competition especially from off-price retailers such as TJX.
  • But for now the capital asset pricing model will be utilized and the multi-factor model will be returned to at a later time to better calculate our cost of equity capital.
computing the cost of enterprise capital wacc
Computing the Cost of Enterprise Capital (WACC)

rEnt = (0% * ($-488,524/$2,064,016)) + (8.88% * ($2,552,540/$2,064,016))

rEnt= 10.99%

share price of american eagle
Share Price of American Eagle

Forecasted Share Price

Current Share Price

beta b using historical prices
Beta (B) Using Historical Prices
  • First I downloaded from Yahoo Finance Historical prices for S&P 500 and American Eagle from the dates of Jan. 1, 2009 to Jan. 1th, 2014 and I choose to use adjusted closing prices for both instead of just regular closing prices because adjusted closing prices take into account any dividends, splits, or reverse splits.
  • I then found the return from month to month and then subtracted out risk-free rate of the 30 Year Treasury.In excel I used the slope formula to calculate a Beta.
  • I calculated a Beta of 0.951 which was relatively close to what I found on Bloomberg which was 1.15 and on Yahoo Finance it was .80.
excel calculation
Excel Calculation

Beta Calculation

Formula’s Used

which numbers are right
Which Numbers are Right?
  • The Beta of .951 which I calculated in excel is more than likely a little low and thinking about it logically with all the internal and external risks associated with American Eagle it is more likely that the 1.15 found on Bloomberg seems like a better estimate.
  • The initial WACC of 10% seemed to low of an estimate, and even the 11% I calculated seemed too low. The 12.8% found on Bloomberg seems like a better estimate.
  • In conclusion, I believe that American Eagle is undervalued by the 20.41% through the use of Bloomberg’s estimate’s of Beta and WACC, but I still do not recommend buying it as of right now until the economy improves. I do recommend a hold on it as American Eagle does pay a dividend.
the end
The End

Any Questions?