Get an Edge With Reward/Risk

Editor's note: This was originally published in two parts on RealMoney. It is being republished as one article as a bonus for TheStreet.com readers.

Like playing poker, successful investing depends on assessing the odds of an uncertain outcome. Ideally, the stocks you own will pay big if your thesis is correct and lose just a smidge if the idea fizzles. This is smart money management; tilt the odds of success in your favor and over a lifetime of investing, small advantages compound into large sums.

In this column, I show how to estimate reward vs. risk, which may give you an edge in 2009. To illustrate, we'll use Ensco International (ESV Quote). Ensco provides offshore contract drilling services to the oil and gas industry. The Dallas, Tex.-based company, founded in 1975, operates around the world.

Our analysis has three steps.

1. Reward. Here we try to figure out what the company is worth if it grows as analysts' expect. We assume the consensus is right, even though studies by David Dreman show the futility of predicting the future. The intrinsic value is $99, assuming TTM GAAP net income of $1.12 billion grows 11% a year for the next five years, 5% a year in the next six to 10 and 3% a year in perpetuity. Other key assumptions include a terminal multiple of 9.5 times, and 0.8% a year share count dilution during the forecast period. With a current stock price of $27, our anticipated upside, or reward, is $72; i.e., $99 to $27.

2. Risk. Here's where we assume things get really bad but short of a bankruptcy, where the stockholders get wiped out. We assume Ensco sells for half of tangible book value, or $14 a share. This is a Depression-era mentality, to be sure. But the ball takes funny bounces, so why not err on the safe side? The implied downside, or risk, is $13; i.e., $27 to $14.

3. Divide reward by risk. Ensco offers $72 of reward vs. $13 of risk, so our reward/risk score is 5.5 times. Since I want a score of 3.5 times or more to buy a starter position, Ensco gets a green light. I am in the process of doing a complete analysis; namely, using the earnings power chart to gauge the quality of Ensco's GAAP net income, identifying a durable competitive advantage and determining if the E&P outfit trades at a substantial discount to intrinsic value. (To learn more, read my book It's Earnings That Count) With a score of 5.5 times, the expected payoff is large enough to justify spending additional time to learn more about this business. If Ensco's score was, say, 1.5 times, then I would move on to the next name in my prospect list.