Estimating Future Volatility
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.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter