Short This Overvalued Stock About To Fall
As investors, we have many tools of the trade at our disposal. Unfortunately, we are self-absorbed in a way: we believe that we have special knowledge unavailable to other investors. Whether you’re an industry insider or a discerning consumer, there are millions of others like you.
This is why I like to turn to novel methods of comparing stocks, especially when those stocks are in the same sector. This helps me look for pair trades outside of arbitrage opportunities (in which you short the acquirer and long the acquired). Today, I turn to the automobile industry.
First, let’s take a look at a standard valuation: discounted cash flow.
Discounted Cash Flow
My discounted cash flow methodology is a bit different from what you normally see online, as I look at both the trend of the DCF valuation and the current mispricing. I’ve programmed this to be plotted so that we can easily see the trend.
Oh, yes – I forgot to mention the stocks of interest:
Ford (NYSE:F)
Fiat Chrysler (NYSE:FCAU)
General Motors (NYSE:GM)
Honda (NYSE:HMC)
Toyota (NYSE:TM)
Tesla (NASDAQ:TSLA)
Now let’s take a look at those DCF valuations:
Ford
NA: Negative cash flow
Fiat Chrysler
NA: Negative cash flow
General Motors
Free cash flow is up, along with growth, pointing to a significant undervaluation of the stock:
Honda
At the beginning of the century, this model implied that Honda was fairly priced, moving upward along with the stock. Then the company fell into negative FCF, and the model blew up a la Ford and Fiat:
Toyota
Toyota’s chart is the only good one so far, with the valuation roughly following the stock. It has implied both overvaluation and undervaluation:
Tesla
TSLA’s history of negative cash flow precludes a valuation.
A New Metric
Because of the overall failure to apply DCF valuations to these stocks, I’ve designed a novel but easily understood metric. Let’s look at the most recent sales numbers of each stock, the corresponding average transaction price, and then the market cap of the stock. From here, we will calculate a multiplier.
Now let’s introduce a multiplier of sorts. We divide the market cap of each company by the monthly sales to get a view of how much each car sold is worth in terms of the total value of the company per month. This is quite an objective measurement in that it ignores speculation, sentiment, and growth.
We are looking for “just the cars, ma’am,” here:
Originally, I planned to take it one step further and compare the multiplier to the average transaction price, as each unit is objectively worth a different price to a different company. But, with the multipliers varying to such an extent while the average transaction price is roughly the same for each company, this analysis would lend nothing extra to our valuations.
What is interesting about such an analysis is that you can interpret the extreme findings as either bullish or bearish.Are TSLA cars really adding 12x more value to the company than Toyota’s cars add to its? This is doubtful, which would imply that TSLA is overvalued while FCAU is undervalued.
Or, perhaps these multipliers imply something extra in the company outside of the mere objective value of the cars. In this case, a higher multiplier implies that the company has more going for it than just cars and possibly includes growth or investor sentiment. The way you interpret this multiplier is important, as it can lead to a strong pair trade.
I edge toward the former explanation: A higher multiplier implies an overvalued stock. In this case, TSLA would be overvalued while FCAU is undervalued. The pair trade would then be to short TSLA and long FCAU.
I think this explanation makes more sense, as you can divide the multiplier by 12 to get an approximate worth of each vehicle per year. For example, each TSLA vehicle sold is worth $756,000 of market value per year in this way. Likewise, a FCAU car sold is worth only $4,000 of value per year to the company. HMC is the most “correctly” valued, with the multiplier corresponding to a $27,750 car, which is almost exactly its average transaction price.
If you disagree with these pricings and believe the market will eventually correct this multiplier – essentially we are talking about a misjudgment of P/E here – you would be wise to make the appropriate pair trade. In this case, your best way to play this market while being hedged is to short TSLA and go long FCAU. But we all know how shorting TSLA works out.
This is why I would recommend using options to short TSLA with limited risk. Here’s my preferred strategy – this is called a broken wing butterfly:
This trade becomes profitable when TSLA falls below 206.61 and gives you all the upside that a short position would without the risk. This is a great strategy on expensive stocks such as TSLA because the options cost so much by themselves. For example, buying one put option would cost you around $2,000, but this strategy allows us to bring the cost down to only $800.
The creative combination of selling and buying options allows us to play big-name stocks such as TSLA at penny stock prices. In this case, we get all the upside of shorting TSLA but none of the downside. Essentially, we are short 100 shares of TSLA but only paid the equivalent of 3 shares of stock!
Play this strategy today and enjoy the gains.
Note: Recently, Tim Plaehn, income expert with Investors Alley, met with the CEO of one of America’s fastest growing specialty banks, and what he told me just blew me away
Tim jotted down all of his notes and put them in this one report for you.
Click here for the full briefing that tells you exactly how and when to get started.
Category: Options Trading
