Monday's market plunge -- sending the Dow Jones Industrial Average below 7000 -- has made it ever harder to find profitability the conventional way. My deep-in-the-money call options trading system, which has a win record of 95-1, sidesteps the conventional buy-and-hold strategy. I look for returns through options plays on undervalued stocks that I expect to pay off more quickly.I get this payoff by setting limit orders $1 above my average call-option contract price. When the contract gets that $1 boost, I cash out. My secret sauce is in the stock picking. Through my Nails on the Numbers newsletter, I issue specific stock picks, strike price and contract prices.
For example, in the case of Home Depot ( HD), the company's shareholder equity remained nearly constant at $17.78 billion to its last fiscal year. Averaging the total shareholder equity for both years, we get $17.746 billion. Dividing the company's net profit of $2.26 billion for the past four quarters by that average book value gives us a return on equity of 12.7%, down from 21.4% a year ago. That drop is probably fairly common in this market because of declining profits at most companies. Yet, some companies have reported an increase in return on equity. Looking behind the bare ROE rates at the actual profit and book values is important, because a jump in the rate of return can be misleading. This is true for IBM ( IBM), which showed a big jump in ROE to 58.8% in 2008, from 36.6% for the prior year. Net income did rise 18.6% year over year to $12.34 billion, but that does not account for such a big change to ROE. Rather, Big Blue's book value shrank an astonishing 52% year over year due to a "remeasurement" of its pension obligations. IBM's shareholder equity dropped to $13.5 billion at the end of 2008, from $28.5 billion a year earlier. That's a big bite out of IBM's retained earnings.
And at Caterpillar ( CAT), ROE climbed a few percentage points in 2008, to 47.5%, as shareholder equity value fell 31.5% year over year to $6.1 billion. Net income growth for the period was flat at 0.5%, or $3.56 billion. So, when looking at profitability, look at the numbers behind the ratios to be sure you're seeing the whole picture. Lenny Dykstra manages Nails on the Numbers, a subscription service sold by TheStreet.com. Mr. Dykstra is 92-0 in his options picks this year. Click here for a free trial to Nails on the Numbers. Mr. Dykstra writes regularly about options trades for TheStreet.com.