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Mark Gomes, PTT Research (1,259 clicks)
Long/short equity, research analyst, tech, IT channel checks
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One of my readers read somewhere that the key to success in the stock market is 1/3 fundamentals, 1/3 psychology, and 1/3 luck. As someone who is always looking for stocks that are poised to triple, I would amend that slightly and say that success is actually 1/3 fundamentals, 1/3 valuation, and 1/3 psychology / luck. I lump psychology and luck together because I believe they are intertwined.
Good and bad luck is simply the timing of positive and negative events. A baseball player who hits .333 doesn't go 1 for 3 every night. He'll have months where he bats .400 and others where he might bat in the low .200s. Through it all, he's always an All-Star.
In the case of Pandora (P), investors could be dealing with the stock market equivalent of Babe Ruth. Because the Internet Music industry is just starting to come into its own, competitors like Pandora will surely employ numerous strategies. We can expect wild swings resulting in many strike outs, but also a great number of home runs.
At times, Pandora will appear to be on a lucky streak (signing lots of deals, partnerships, etc). During those periods, investor psychology will surely get frothy. Just as often it will likely go through dry spells, where good news doesn't come as easily. Indeed, some of the news will cast doubt on the company’s great potential. With this “bad luck” investor psychology will turn negative. The two go hand in hand.
The key to successful investing is in knowing that your stock is an All-Star, though in sports it's easier than in the stock market. First of all, there's a lot less money on the line when it comes to your favorite ball player (at least there should be!). Trusting in your stock is a lot more nerve wracking when its share price seems to drop every day.
Secondly, by seeing your favorite player swing the bat several times a week, you gain confidence that he's a pro… even when he goes on a hitless streak. In contrast, you don't get to hang out at Pandora’s headquarters several times a week (unless you’re lucky enough to work there). That makes it more difficult to have faith in Pandora's performance as an All-Star.
This is where fundamentals and valuation come in.
By becoming an expert in the principles of fundamental analysis (or relying on one), you can build confidence in your companies’ fundamentals. If you have done that, you won’t worry when your stocks are falling. In fact, you may even root for it. In my opinion, there’s nothing more fun than backing up the truck when your All-Star is down and making a killing when it inevitably goes back on a hot streak.
But when should we back up the truck? That’s where the principles of valuation come in. Too many investors rely on rudimentary measures of value, like P/E. I prefer to focus on determining two price points – the LOWEST price to which it could fall and the HIGHEST price it may be able to achieve.
The low point should be the price at which we could acquire the whole company and make a profit with near-100% surety. To determine this price, an investor needs to examine all of the company’s asset and liabilities. This goes beyond the balance sheet. Companies almost always have asset and liabilities that transcend the balance sheet (i.e. patents, tax assets, brand equity, etc). Potential acquirers will consider all of these factors, so why shouldn’t we? After all, when you buy shares of a stock, you are acquiring the company. The fact that you are only acquiring a piece shouldn’t excuse us from knowing as much as someone who would acquire the entire enterprise!
The high point can be tricky, but we at least need to make an educated guess. Potential earnings and comparable companies (a.k.a. “comps”) are a couple of good places to start. When looking at potential earnings, we need to estimate the company’s potential growth rate and potential profit margin. Often times, management will provide an “operating margin target”. This tells us how much profit the company hopes to eventually generate on each dollar of revenue. If the target is reasonable, we can calculate the potential profit, slap a reasonable P/E on that number, and voila.
Alternatively, we can look at the valuation of comparable companies and make an assumption regard where our company’s valuation might eventually go in relation to the comps. For example, Pandora is currently valued at $2 billion. Meanwhile, Sirius (SIRI) is valued at $7 billion. If you believe-- as I do-- that Pandora will someday be as great, big, and profitable as Sirius, then you can assume that Pandora might someday achieve a $7 billion valuation too.
In other words, you might conclude that Pandora’s shares are poised to triple.
Once you’ve completed this exercise, you will have your high and low price points. These represent my definition of RISK and REWARD. At this point, all you need to do is plot the current stock price against those two numbers and you’ll know whether your investment is at risk, or in line for a great reward.
For example, if your rock-bottom valuation is $10 per share but you see potential for it to hit $30, you’ll have the chance to triple your money if the stock gets down to your lower-limit price. However, all else being equal, if the stock is sitting at $20, your risk is as great as your potential reward. In other words, the stock could go up $10 to $30 or down $10 to $10. Call me crazy, but I much prefer the opportunity to triple my money versus a 50/50 bet.
To see how this applies to Pandora, examine the following chart:
Figure 1 – Risk & Reward Chart for Pandora
Click to enlarge


As you can see, I have plotted Pandora’s share price since the day of its IPO. I have also extended the chart out to the end of 2012, an arbitrary date, which I have chosen to be my investment time horizon. If my research leads me to believe that Pandora should be worth as much as Sirius, then my target price is $45 per share (which would give P the same $7 billion market cap that SIRI currently enjoys). I placed that point at the upper right of the chart. At the same time, I have prepared myself for Pandora’s stock to fall to as low as $10, which is represented in the lower left corner of the chart.
I can now draw a line from Pandora’s recent high to the upper right corner of the chart. This represents my prediction of the highest price that Pandora might achieve at any point between now and the end of next year, when I think it could hit $45.
Once that’s done, I can draw two parallel lines. One starts from my $10 low and the other (dashed) sits halfway between the high line and the low one. If my assumptions are correct, the lower line will represent support. Any time that Pandora touches that line should represent a great buying opportunity.

The dashed line represents the mid-point of Pandora’s risk and potential reward at any point in time (currently $15 per share). By buying the stock below the line and sitting tight above it, we can maximize our returns (assuming we are right about its $45 price target). As you can see, if the stock goes to $45 by the end of next year, today's buyers will have earned a 150% annualized profit. In contrast, the parallel lines only move at half of that rate -- 75% annualized.
Keep in mind that this is just an example. It can be adjusted to depict your personal high and low price targets for Pandora, or any other stock.
In Part 2 of this article, I will provide the actual Risk & Reward charts that I use to trade some of the stocks highlighted in my “Stocks That Are Poised to Triple” series on SeekingAlpha.com.

Disclosure: I am long P.

Continue to Part 2 >>

Source: Identifying Stocks That Are Poised to Triple Part 1