More of this Feature • Back to Segment 1 • Abercrombie & Fitch • Analyzing Abercrombie • Brown Safety • Analyzing Brown Safety • Quiz - Lesson 4

Join the Discussion "I am planning on buying into a tax-free municipals fund such as one of the Franklin funds. I understand one can buy "A" shares with up-front expense loading, or "B" shares where expense loading doesn't occur until one sells." - DoctorJeff91

Related Resources • Investing Lesson 1 • Investing Lesson 2 • Investing Lesson 3 • More Lessons

From Other Guides • Income Statement • Expensing Stock Options on the Income Statement • Extraordinary Items on the Income Statement

Elsewhere on the Web • Income Statement Analysis • Income Statement Ratios • Income Statement Calculations and Ratios

Gross Margin
The first thing we do is calculate the company's gross margin.  Taking the gross profit of $558,034 and dividing it by $1,364,853, we come up with .40996, or almost 41%.  Applying the same calculation to previous years, we find that in 2002, company's gross margin was 41.2%, compared with 43.7% in 1999.  As a potential owner of the business, you want to find out why the gross margin is falling, and if the trend is expected to continue.  If the industry is hit hard by economic conditions, calculate the gross margins over the past three years for Abercrombie's competitors [such as Pacific Sunwear, Gap, or American Eagle] to see if they are experiencing the same problem.

Operating Margin:
We calculate the operating margin as 19.9% during 2001, 20.5% in 2000, and 23.5% in 1999.

Interest Coverage Ratio:
You will notice that the interest income is recorded as net.  If you think back to the lesson, you should remember that this means the total interest expense and interest income were added together to offset one another and the resulting figure recorded.  In Abercrombie's case, the company recorded -5,064 in interest.

Using this information to calculate the interest coverage ratio, we take the earnings before interest and taxes [EBIT], of $271,458, and divide it by the total interest expense of $5,064.  The answer is 53.60.  What does this mean?  The company can afford to make its interest payments 53+ times.  Obviously, it is going to have no problem making its relatively miniscule payments.

Net Profit Margin:
In 2001, Abercrombie had a profit margin of 12.4%.  In 2000, the profit margin was 12.8%, while in 1999, it stood at 14.5%.  Once again, this doesn't mean much unless you compare it to the profit margins of competitors.  Even then, it may be inaccurate because of pricing strategy [for instance, Neiman Marcus may have a slightly higher profit margin than Wal-Mart, but that is because of the two retailers have different pricing strategies and business models.]

Return on Equity - ROE
Here's where we get to the juice.  To quickly calculate Abercrombie's return on equity, take the average shareholders' equity [$595,434+422,700 ÷ 2] of $509,067 and divide it into the net profit of $168,672.  The answer, .3313, or 33.13%, is the return that management is earning on the retained profits.  Obviously, your pocketbook will be much faster enriched if you allow the company to retain all of the profits instead of paying them out as dividends [can you reinvest the earnings at 33%?  Probably not!]

If both Abercrombie and a competitor were selling for ridiculously cheap [say 3 times earnings], you would want to go with the business that was generating the highest return on shareholder equity.  Considering the average corporation earns between 10 and 15% on its equity, Abercrombie's high ROE should make your mouth water.

Asset Turnover
Taking Abercrombie's average assets of $680,061.5 [$770,546+$589,577 ÷ 2], and dividing it into the total revenue of $1,364,853, we find the company has an asset turn of 2.0.  There are several general rules that should be kept in mind when calculating asset turnover. First, asset turn is meant to measure a company’s efficiency in using its assets. The higher the number, the better [although investors must be sure compare a business to its industry. It is fallacy to compare completely unrelated businesses.] The higher a company's asset turnover, the lower its profit margin tends to be [and visa versa].

Return on Assets
Multiplying the 12.4% net profit margin by the 2.0 asset turn, we get .248, or 24.8% return on assets.  Using the second formula, we divide the net income of $168,672 by the $680,061.5 average assets, which we discover is .248 or 24.8%.

Share dilution
As a conservative investor, you should base your valuation on the diluted earnings per share.  Unfortunately, if you remember back to our discussion on share dilution, you haven't forgotten the clandestine tactics Abercrombie took by not including all possible stock option dilution in the diluted EPS figure:

From Abercrombie & Fitch’s 10K:

Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of Class A Common Stock were outstanding at year-end 2001, 2000 and 1999, respectively, but were not included in the computation of net income per diluted share because the options’ exercise prices were greater than the average market price of the underlying shares.

If you believe that Abercrombie is undervalued at the current market price and therefore expect the stock to rise, some of these underwater options may become exercisable, reducing the EPS even further.  You would be wise to make a provision for these in your valuation [for instance, if you take the net income of $168,672,000 and divide it by the diluted EPS of $1.65, you can see that management estimates the possibility of a total of 102,225,454+ shares outstanding.  You may want to add the 5,630,000 underwater shares to this figure, making the fully diluted outstanding shares stand at around 107,855,454.  Now, taking the net income of $168,672,000 and dividing it by the true fully diluted figure, you would get diluted EPS of $1.56 instead of $1.65.]

Although there is a possibility of these shares not being exercised, practiced conservatism can make a big difference to your pocketbook over time.

Final Thoughts on the Company
A quick look at the income statement shows that sales, gross profit, operating profit, and the basic and diluted EPS have increased steadily for the past few years, even though the gross, operating, and profit margins have fallen slightly.  These factors, combined with the high return on shareholders' equity should leave an investor fully satisfied with the business.  Management has clearly created shareholder value by increasing the amount of equity on the balance sheet, and reinvesting profits at a high rate of return.  If the company's shares were to ever trade low enough, an enterprising investor should have no problem holding Abercrombie in their portfolio if the current conditions persists.

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