Even In a Bear Market, This Stock’s Undervalued
General market conditions look increasingly bearish to many investors. They see the major stock market averages reaching new all time highs and realize this means the indexes are becoming more overvalued. They see that valuation metrics like the price to earnings (P/E) ratio are also near all time highs.
As the market moves higher, the stock market is increasingly becoming a market of stocks. This means selectivity is becoming more and more important. It’s no longer enough to buy an index and hope the rising tide will lift all ships. Many investors see it as a time to look at valuation of the individual stocks.
That leads to the question of what to look for when considering the valuation of an individual stock.
Valuation Over the Market Cycle
Many investors look at valuation like a snapshot. They consider the stock’s current P/E ratio, for example, or consider simply the stock’s current dividend yield or other valuation metric. This can be useful, but it is actually a short term approach.
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Valuation is found with a formula and the formula usually includes the current price of the stock. This means the current valuation is largely determined by the current stock price. Investors focusing on the long term should consider using a different approach that matches their time frame.
When looking at the long term, a metric that considers valuation over a market cycle could be used. This has been popularized with the cyclically adjusted P/E ratio, or CAPE, a metric popularized by Nobel Prize winning economist Robert Shiller. CAPE is applied to the broad stock market.
CAPE is a complex calculation that adjusts for inflation and uses average earnings over a time frame of ten years. This allows investors to view the average valuation of the stock market over the long run.
This type of analysis can also be applied to the analysis of an individual stock. In fact, this approach was the valuation technique originally recommended by David Dodd and Benjamin Graham in Security Analysis, the first book ever published on fundamental analysis.
Again, the formulas for this technique can be fairly complex. But, there are some shortcuts that can be used to develop an opinion on whether a stock is overvalued or undervalued. This information can be used to make a decision as to whether a stock is a buy or a sell.
A Long Term View of Ford
One group of stocks that lends itself to this approach is the auto manufacturers. Sales of these companies are actually tied to the business cycle. Consumers and businesses tend to buy more cars when the economy is expanding and they buy less when the economy is contracting.
This tendency can be seen in the chart below which uses data from the Federal Reserve. The cyclical nature of auto sales is visible in the data.
Not surprisingly, strong trends can be seen in the share price of stocks in the industry. The chart of Ford Motor Company (NYSE: F) is shown below. This is a long term chart using monthly data.
Ford has generally been in a downtrend since 2014. This is in line with the trend in auto sales which peaked in 2015. The stock market is forward looking and we would expect the stock price to peak before the sales data peaks.
Over the past year, Ford has been trading near $11 a share, an area where value investors seem to find the stock attractive. This provides support, which is an area on the chart where price declines seem likely to stop as buyers enter the market.
Valuation of Ford From a Long Term Perspective
The next chart shows that the support level appears to be confirmed by the P/E ratio which is shown at the bottom of the chart. The P/E ratio has been fairly steady for nearly two years.
The question for investors is whether or not the P/E ratio is likely to turn up or down from its consolidation level. One way to answer this question is to compare the current P/E ratio to the average P/E ratio of the past five years.
Over the past five years, F has traded with an average P/E ratio of 16.3. Over that time, earnings per share (EPS) averaged $1.57. While that was the average, there was a great deal of variability in the EPS, which ranged from a low of $0.32 to a high of $3.04. Focusing on the average can help us find the stock’s long term fair value.
With average EPS and an average P/E ratio, F should be worth about $25 per share. The current price is less than half that level and in the long run, Ford could deliver a triple digit return.
Trading the Long Term With Options
options trading strategies are a versatile trading tool and it is possible to use options to take a long term position in a stock. In this case, when the stock is expected to rise, the trader can simply buy a covered call option. Long term call options expiring more than a year from now are available for Ford and that matches the time frame of the analysis of the stock presented above.
Buying a call has many of the same benefits of owning the stock. The upside of the position is potentially unlimited. However, unlike when owning a stock, the downside risks are strictly limited and can never exceed the amount paid to buy the call.
The potential rewards and risks of owning a call option are summarized in the chart below.
Source: The Options Industry Council
One disadvantage of options relative to stock ownership is that option holders do not receive dividends which can be substantial. For F, the dividend is $0.60, a yield of more than 5% at the current price. The potential rewards of the call need to be significant to offset this payment.
A Specific Trading Strategy
For Ford, the January 2019 $10 call is trading at about $2. This call will be worth at least $5 of Ford reaches $15 a share before the option expires on January 18, 2019. Owning 100 shares of stock in Ford would require more than $1,150 of trading capital.
By the time this option expires, the 100 shares should generate $75 in income. That means the stock could deliver a total return of about 35% if Ford reaches $15. The downside risk could be substantial if F declines, even with the dividend income which could offset part of any loss.
Owning two call options could deliver a larger gain if F reaches $15 per share than 100 shares of the stock. The two calls require about one third of the trading capital needed to buy 100 shares of the stock. That means the January 2019 $10 call on F could be the best trade available for this stock.
At $15 a share, this call would deliver a triple digit return.
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