Valuation and Stock Options

An Alternative to Intrinsic Value

This page on valuation and stock options isn't so much about valuing stock options per se as much as it is a continuation of a conversation on how to value stocks.

As a practitioner of what I call Leveraged Investing, I find that the old value investing concept of intrinsic value (i.e. the "true" value of a company) just isn't all that helpful for me.

For me, I don't try to determine intrinsic value (i.e. the price I believe the stock should trade at) but rather what the stock is likely to trade at over the near to intermediate term. As long, as the company continues to grow its earnings, and as long as it wasn't wildly overvalued in the first place, I know that it's just a matter of time before the stock moves higher.

So the rest of this page details how I use that information to my advantage, and how in this instance, even when the trade seems to go against me, as long as I exhibit patience and common sense, I can still continue to make money.

Valuation and Stock Options - An Example

At the time of this writing (the evening of July 28th, 2011), I have a number of open naked put positions on Pepsico (PEP), all of which are underwater.

Today the stock traded up $0.03 to close at $63.89. Even though earnings were up 10% year over year, shares took a bit of a nose dive following the company's earnings release prior to the market's opening on 7/21/11. The drop was based on concerns about the impact of rising commodity prices, some apparent unease about Pepsi's plan to increase prices on already stressed consumers, and a generally flat North American market.

At the time of this writing, I have 2 short puts on PEP at the $70 strike price and another 4 at the $65 strike. All 6 have August expiration dates.

On a sidenote, the 4 naked puts at the $65 strike I originally set up as bull put spreads by simultaneously buying 4 long puts at the $62.50 strike - but when the stock sold off, I sold the long puts for a small profit.

That move also increases the potential profit on the remaining short $65 puts should the stock rebound, since I eliminated the "debit" portion of the trade.

That adjustment is not without risk, of course, as it significantly increases my potential downside liability, and if the stock continues to fall and ends up several dollars lower by expiration, it will have been a very bad move.

A little more background: the PEP share price bounced around the $70 level throughout the second half of May and again during the early part of July. I'd actually been nibbling on naked puts at the $70 strike price since the end of April, sometimes rolling them out, sometimes closing the options early for various profits. I also successfully wrote some additional $65 puts on PEP at the beginning of the year.

All told, at the time of this writing, I've netted over $900 in realized income on PEP options in the first 7 months of 2011 on a total of 11 closed positions. That's one reason I'm not panicking when it comes to the other 6 open positions or feeling particularly foolish about technically being underwater on the trades.

And how I actually go about valuing the underlying PEP stock is another reason . . .

Valuation and Stock Options - Why Being Underwater Doesn't Freak Me Out

If I were first and foremost a trader, my perspective might be different. Maybe I already would've cut my "losses" once the stock dropped below a certain level.

But I have the perspective of a long term investor who uses options to perpetually lower the cost basis (or boost returns, if you prefer to view it that way) on a portfolio of the highest quality companies I can identify.

And for me, PEP definitely falls under that category.

So what if the stock is down 10% from its recent highs? The company continues to grow its earnings. Yes, the rising price of potatoes in Russia is a headwind, and there is a legitimate concern that the company's earnings growth is slowing, but it's not like people are going to stop eating potato chips or drinking Gatorade anytime soon (or, for that matter, stop consuming any number of Pepsi's vast beverage and snack products worldwide).

So getting back to the valuation alternative to intrinsic value (i.e. the price at which market should value a business), I take a much lazier and common sense approach.

Valuation and Stock Options - How to Value Stocks the Lazy Way

I look at PEP and I see several things. I see a company that:

continues to grow its earnings (the 2011 estimates are an 11% increase over 2010)
has enough free cash flow that it's expected to buy back $2.5 billion of its shares this year
has increased its dividend for the last 39 consecutive years (a 7% increase this year).
has a forward looking P/E of 13.2

With a 13.2 forward looking P/E, it doesn't seem to me that the is significantly overvalued. So I ask myself these two questions - how likely is it that PEP will hit $70/share again and how long is it that I will have to wait?

My conclusion? It's just a matter of time.

The Importance of Patience - Being Underwater Does Not Necessarily Mean You're Drowning

I don't have to know the exact level of earnings growth, dividend growth, or precisely how many shares will get repurchased. But taking into consideration that there's a high probability that all three of these factors will remain positive, then it seems to me that a $70 PEP share price (or higher) is also something that's high probability.

The only unknown is the timing. But even there, I have common sense on my side. It may not be next month, it may not be 3 months, it may not even be 6 months, but at some point - and we're talking months here, not years - I'm very confident PEP will once again be trading somewhere near the $70/share price.

And that's the beauty of being on the selling side of options - I don't have to be perfect. If I'm somewhere in the ballpark, I can still continue to make money. In fact, I don't even need PEP to trade above $70/share in order to continue rolling the puts for continued net premium.

Don't get me wrong - this is not the most enjoyable experience, nor is it entirely stress free. Believe me, it's a lot more fun when the options you write easily expire worthless.

And in hindsight, it would've been nice to not have any open positions on PEP until the stock broke below $64/share and then write all 6 puts at the $62.50 strike. But I don't have a crystal ball - and in the end I don't believe I need one.

I don't know where the stock will be trading in roughly 3 weeks when the 6 open short put positions expire, but unless the stock continues to fall, it's very likely that I will be able to roll all 6 positions out one month at their current strike prices and still generate a net credit.

Rolling the $70 puts out one month, when they're this deep in the money, is likely to produce only a very, very small net credit, especially once commissions are factored in. But the $65 puts, depending on where the stock closes in 3 weeks, might be able to be rolled for some decent premium.

When I roll or otherwise adjust an option trade, I look at the totality of the position, not just the individual components. So in this case, I'll look at the total cost of closing out all 6 puts and the total level of new premium income received for rolling.

And at this point, I'm still confident that the roll will produce an overall net credit.

Am I maximizing premium income? Of course not. But I am still collecting net premium and it's still going to be a lot more income than what's available to the long stock only investor of PEP whose only source of income is dividends and who, like me, is also waiting for the PEP share price to climb back to $70.

In this case, we both get paid to wait - it's just that I get paid more.

The primary reason why I'm arguably so laid back when it comes to how to value stocks, is that my Leveraged Investing approach gives me a lot more flexibility to make money than if I were a traditional long only investor.

By combining trading and investing, I don't need a stock to drop to a certain level in order to get a good entry price, and I don't need the stock to stay above a certain price and continue climbing in order to see the value of my investment account compound higher.

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