Although mathematically simple, taking a company’s price and dividing it by its earnings can tell an investor a great deal. The P/E ratio, as it is called, shows how much investors are willing to pay for a dollar of earnings. So, if a company has a stock price of $20 and earnings of $1.00, its P/E would be 20.0. Each dollar of earnings is worth $20 to the market. If that same company, trading at $20 per share, earned $0.50, however, the P/E would be 40—investors would be paying $40.00 for each dollar of earnings.
The price to earnings ratio is a valuation metric, helping to decipher if a stock is expensive or not. Although some use absolute metrics (a P/E over 20 is expensive, for example), P/E is most useful on a relative basis, comparing one company to its historical norms, to another company, or to an industry or market average. It is a way to measure that voting machine mentality of Wall Street about which Benjamin Graham wrote. The thought is that growth and momentum investors are willing to pay more for a dollar of today’s earnings to invest in a quickly growing company. A value investor, meanwhile, would prefer to wait until a company is “on sale” and trading at a low P/E multiple.
Every week Value Line publishes screens of the highest P/E ratios in the Index section of The Value Line Investment Survey. For this screen, we have chosen to highlight Under Armour, Inc. (UA).
Under Armour, Inc.
Under Armour manufactures sports apparel, footwear, and accessories for men, women, and children. The company uses moisture-wicking polyester fibers in many of its products to remove perspiration from the skin and keep athletes cool. This is in contrast to traditional cotton fabrics that can become heavier and trap in heat after absorbing perspiration. Under Armour also has a line designed for cold weather activities. The sports that UA focuses on are football, baseball, lacrosse, softball, and soccer. Accessories include gloves, socks, uniforms, hats, and bags. The company sells its products primarily with its UA and Under Armour labeling to college athletic departments, league teams, sporting goods chains, and department stores.
Shares of Under Armour have fallen 18% since reaching an all-time high on September 14, 2012. A primary reason for the decline was lower fourth-quarter gross margin guidance. The weaker outlook was due to several factors, including discounting of excess inventory at factory stores and a mix shift toward lower-margined footwear. The company has also been having “delivery issues” (primarily in the fleece category) following the addition of some factories that have proven to be relatively unreliable. In response, the company has been forced to airfreight more merchandise to meet strong end demand. This trend contributed to the 130 basis point gross margin compression in the fourth quarter and is expected to continue in the first quarter of 2013. Management is trying to improve capacity planning and introduce factories at a better pace. Still, margin expansion is expected to be modest this year as the aforementioned obstacles are resolved and offset by favorable comparisons in the back half of the year. Long term, the company hopes to improve profitability by charging higher prices for innovative products.
Despite weaker near-term margins, revenue growth remains impressive, and prospects for further improvement are palpable. UA’s primary strategy for an expanded top line is apparel diversification. Indeed, the fast drying Charged Cotton line was up 90% year over year in the fourth quarter while the water-resistant Storm Fleece platform grew 300%. Meanwhile, the company is getting ready to release Armor 39, a biometric performance monitoring system where a wearable strap works with an accompanying watch or a smartphone app to provide a “willpower” score of 1-10 that shows a user how hard they are training.
To be sure, expanded women’s and children’s assortments should also fuel growth, and we give little credence to the notion that UA’s core men’s market has become saturated.
Although cleats are the only subcategory in the footwear arena where Under Armour has achieved significant market share thus far, the company is releasing new basketball and running shoes in hopes of improving its position against industry stalwarts such as Nike (NKE) and Adidas.
Gaining recognition in the footwear space will no doubt be an uphill battle, which is why we are more optimistic about the benefits of domestic and international store expansion. Under Armour’s primary retail partner, Dick’s Sporting Goods (DKS), will be rolling out over 70 Under Armour store-within-a-store locations this year. Floor space and inventory will also be expanding at rural sporting goods retailer Hibbett Sports (HIBB), as well as department stores like Macy’s (M) and Dillard’s (DDS).
Although there are some near-term challenges on the supply side, we have confidence in the innovative products Under Armour is bringing to the table. We also view sporting apparel and accessories as less likely to be hurt by potentially slower consumer spending than other retail categories. Despite recent price weakness, the equity still trades at over 40 times our forward earnings estimate. Therefore, only momentum investors should consider this growth stock.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.