35 lines
2.3 KiB
Plaintext
35 lines
2.3 KiB
Plaintext
Risk and the Intelligent Option Investor • 267
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Let’s assume that the present market value of the shares is $16 per
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share. This share price assumes a growth in FCFO of 8 percent per year for
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the next 5 years and 5 percent per year in perpetuity after that—roughly
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equal to what we consider our most likely operational performance
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scenario. We see the possibility of faster growth but realize that this faster
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growth is unlikely—the valuation layer associated with this faster growth
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is the $18 to $20 level. We also see the possibility of a slowdown, and the
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valuation layer associated with this worst-case growth rate is the $11 to
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$13 level.
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Now let’s assume that because of some market shock, the price of the
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shares falls to the $10 range. At the same time, let’s assume that the likely
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economic scenario, even after the stock price fall, is still the same as before—
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most likely around $16 per share; the best case is $20 per share, and the worst
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case is $11 per share. Let’s also say that you can sell a put option, struck at
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$10, for $1 per share—giving you an effective buy price of $9 per share.
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In this instance, the valuation risk is indeed small as long as we are
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correct about the relative levels of our valuation layers. Certainly, in this
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type of scenario, it is easier to commit capital to your investment idea than
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it would be, say, to sell puts struck at $16 for $0.75 per share!
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Thinking of stock prices in this way, it is clear that when the market
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price of a stock is within a valuation layer that implies unrealistic economic
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assumptions, you will more than likely be able to use a combination of
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stocks and options to tilt the balance of risk and reward in your own
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favor—the very definition of intelligent option investing.
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Intelligent Option Investing
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In my experience, most stocks are mostly fairly priced most of the time.
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There may be scenarios at one tail or the other that might be inappropriately
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priced by the option market (and, by extension, by the stock market), but
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by and large, it is difficult to find profoundly mispriced assets—an asset
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whose market price is significantly different from its most likely valuation
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layer.
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Opportunities tend to be most compelling when the short-term pic-
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ture is the most uncertain. Short-term uncertainties make investing boldly
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