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Estimating Future Volatility


Many Minyans have asked me how we evaluate option prices; in other words, how do we determine whether implied volatilities are cheap or rich. We certainly look at historical statistics like price patterns (such as high versus low prices over time algorithms: lognormal returns) and historical volatility (the square root of the price variance), but these only give us a benchmark or range. We also look at a company's balance sheet for excess leverage: we believe high leverage will add to future volatility. One element that I want to talk about now that most volatility traders do not look at, which also may be of interest to just straight long and short traders/investors, is valuation.

Valuation is a sensitive subject with many investors because it is nebulous. It may be fairly certain now, but what is it in the future? In physics, the Heisenberg principle states that when trying to locate a subatomic particle like an electron, you can either know its position or its momentum, but not both. The more certain you are about its position, the less you know about where it is going. Valuation is similar. Even though you know what is happening now, you must make all kinds of assumptions to extrapolate that into the future. This is precisely what we are analyzing in evaluating volatility: not valuation, but expectation.

An example will make this clear. KLAC is currently trading at 86 times trailing earnings and 56 times estimated future earnings. This is certainly a high current valuation, but what is important to us is the expectations built into an investor's mind to validate the current stock price and the likelihood of them occurring. The fastest growing company in the technology space (although it is not directly comparable) is MSFT, which trades at 28 times trailing earnings and 25 times estimated future earnings. If we use this as a base, then any reasonable investor in KLAC would (1) expect to make a reasonable rate of return in owning the stock, (2) believe that the multiple must come down to a reasonable level when the company is at peak earnings, one that cannot be too much different from MSFT, and (3) the company will have a growth rate to substantiate the current price with a reasonable future multiple.

In order to earn a 10% compounded return on KLAC at $56 over the next five years, the stock price would have to appreciate to $90. In order for the stock to be at $90 in five years at a 25 multiple, the company would have to grow earnings by 28% per year to $3.57 per share. Our analysis (fundamental) corroborated by outside sources based on industry capacity and growth shows peak earnings in KLAC at around $2.50 per share. This represents a 36 multiple with the stock at $90; the stock would be at $62 at a 25 multiple.

What we really want to access is not whether or not KLAC is valued correctly, but whether expectations will be disappointed somewhere along the way. Even if everything goes perfectly for the company, it will be challenging for it to live up to investor expectations. This of course, accounts for no risk of things going wrong. We like to be long volatility when the price is cheap enough that if nothing goes wrong, there is a reasonable chance that expectations will not be met. If something does go wrong, we could experience a tail event in the stock, something the option prices are not discounting at all.
Position in KLAC

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