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 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.
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.
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
) 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.
Another company I like is
( KHD). Its reward/risk score is 13.6 times, meaning every dollar of risk offers $13.60 of reward. But beware that earnings forecasts are falling, and per-share growth is expected to decline 55% year over year.
also earn high marks by this measure.
AAPL), I get a score of about 2.1 times, meaning that at $86, you get $2.10 of reward for every dollar of risk. Since Apple's free cash flow is higher than GAAP net income, I use the former to estimate intrinsic value. If free cash flow converges to GAAP net income, then intrinsic value and reward/risk may be overstated. Since Apple has a competitive advantage (its
is speculative, however) my worst case scenario uses tangible book. To earn a reward/risk score of 3.5 times, Apple's stock must fall to $66 with no change in any key assumptions.
Another tech blue chip,
, earns a reward/risk score of just 0.1 times, meaning there are 10 cents of reward for every dollar of risk. Two factors that depress its score are a price-tangible book value of 4.3 times (the higher the P/TBV, the further a stock can fall) and my forecasted 3.5% annual increase in share count for the next decade. The more shares outstanding a company has, the smaller your share of the pie. Google's stock must fall to $123 to earn a 3.5 times reward/risk score. As with Apple, my worst case scenario uses tangible book value.
Although reward/risk scores are in tenths, when it comes to stocks, I am not a fan of decimal points. Fractions create a false sense of precision, which can get you into trouble.
These scores are also sensitive to small changes in assumptions. In Ensco's case, if we lower the earnings growth forecast for the next five years to 10% from 11%, then reward/risk drops to 5.1 times from 5.4 times. Or, if share count stays flat for the next decade, then reward/risk improves to 6.0 times. So take these scores with a grain of salt. You do not need to know someone's weight to know he or she is overweight, and you do not need reward/risk in tenths to know the odds of success are in your favor.
Also, tangible book value may be an imperfect proxy of risk. For example, no credit is given to intangibles like brand names, patents and customer lists. If we account for these off-balance-sheet assets, then reward/risk scores for many "new economy" companies improve.
On the other hand, the more specialized a firm's tangible assets, the harder it may be to sell them in a crisis. In 1999, satellite phone operator
went bankrupt less than a year after operations began. The system that cost
( MOT) $5 billion to build fetched just $25 million in bankruptcy. Tangible book value overstated Iridium's reward/risk score.
With this economy, you'll want to update your assumptions every few weeks. While updating my spreadsheet for this column, I noticed the consensus growth forecast for several companies in my portfolio fell. In some cases, reward/risk scores are now below 2.0 times, so I sold the stocks. Expect further downgrades ahead as we grind through this recession.
This was originally published on
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At the time of publication, Heiserman was long KHD, RDC, OMG, DWSN, RTI, WDC, ESV, AAPL and GOOG, although holdings can change at any time.
Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored
It's Earnings That Count
. For additional information, please visit
Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback;
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