Step one in the investment decision process lies in identifying companies that are high quality. Whether that's through their moats, their operational excellence, their cash generation, their growth prospects, their credit ratings, their dividend or any other factors the high quality companies are the source of long term investment gains.
Step two in the investment decision process is where you determine what price you are willing to pay for shares. This is a trickier step because it generally entails making assumptions about future growth and is likely the step that has the most variance among investors.
Some use a ratio of the current price to the 52 low and 52 week high. Others use comparisons to traditional valuation multiples such as price to earnings, price to cash flow, price to book value, dividend yield or just about any other per share financial metric. Still others will use some kind I estimation of future dividends or cash flows of the company and discount them back to the present. Personally, I use a combination of many of these but whatever valuation method you use the end goal is a price target.
Once you've identified a price target you can now move on to the actual purchase of shares, of course there's still plenty of choices for that as well. You can set up a limit order to purchase the amount of shares of the company at a specific price and wait for the price to reach your price target. There's also the options market which is a valuable and often overlooked opportunity to generate extra income.
Over the weekend I re-analyzed Visa, Inc. (NYSE:V) (Analysis Here) and determined that the price at the time, $71.56, was likely on the high end of fair value. On Monday shares of Visa declined over 5% to $67.77, appearing to trade down with the financial sector despite not having comparable risks to traditional financial companies.
Visa is a Dividend Challenger with 8 consecutive years of dividend growth. After the decline Monday, shares offer investors a current yield of 0.83%.
Visa is an extremely profitable company largely due to their low capital requirements in order to grow the business.
Over the last 5 years and the TTM period Visa has converted over 44% of revenue into operating cash flow with an average of just under 9% of operating cash flow need for capital expenditures. That leads to a very high free cash flow margin of 41% over the same period.
Since Visa is swimming in cash that allows them to reward shareholders through both dividends and share buybacks. For Fiscal Years 2011-2015, inclusive, Visa's total shareholder payout (dividends plus net buybacks) has totaled $19.18 B.
The ratio of cash for buybacks to dividends is a bit heavier on buybacks that I prefer, but it's hard to argue with 13.5% of the shares being bought back since the end of Fiscal Year 2011.
Checking in on the valuation
As of the closing price from Friday shares appeared to be on the high end of fair value trading at a TTM P/E ratio of 25.7 and a 2016 Forward P/E ratio of 25.5. The 2017 Forward P/E ratio was 22.0.
At those levels investors with a medium to long term time frame would likely track the business performance of Visa.
The following chart shows the potential price trajectory using the forward earnings estimates for 2016 through 2020 at varying P/E ratios.
The following table shows the future projected returns using Friday's closing price of $71.56.
However, as I mentioned earlier the share price declined over 5% on Monday without a corresponding change in the fundamentals or growth prospects of the company. The decline has unlocked more value in the shares and thus increased future expected returns.
Here's the updated returns chart after Monday's share price change.
The one day share price decline increased the 10%+ return scenarios from 10 to 13 assuming normal market and economic conditions.
For a more detailed look at Visa and the return projections please refer to my analysis of Visa performed over the weekend. In it I go into more detail about the business, profitability, cash flow, shareholder friendliness, growth prospects and risks to the company. You can find the analysis here.
How to enter a position
After the decline on Monday the valuation prospect looks much better than on Friday. There's been no change to the fundamentals or profitability of Visa; rather, the market is just being irrational over concerns of a looming global recession.
Investors looking for an opportunity to add a high growth option to their portfolio have been given a gift by Mr. Market. The current price of $67.77 is attractive to initiate a long term position.
However, I see three reasons to not purchase shares via a limit order at this time.
- The current market environment is choppy, to say the least, and the share price could very well decline further leading you to miss out on a better bargain.
- If, like me, you already have a position in Visa and want to have the opportunity to purchase shares even lower even if the share price moves higher.
- If you have a larger amount of capital readily available.
That leads us to the options market.
I'm going to run through the process of analyzing call options for Visa that are available as of the close on Monday, February 8th.
What I like about options is that when selling options you receive cash up front in the form of the premium. That premium can be used immediately for whatever you want.
When you sell call options you are giving the buyer the option, but not the obligation, to purchase shares from you at the agreed upon strike price sometime between now and the agreed upon end date. In order for the buyer of the option to execute a call option the share price must be trading higher than the strike price of the option.
Terms and Information
- Strike Price - The agreed upon price for the option contract at which it can be executed.
- Execution Date - The end date for the option at which time the contract will expire. In all cases examined below I'll be looking at options expiring on January 20, 2017.
- Premium - The amount of cash received upfront if you're the seller of the option
- Each option contract represents 100 shares.
- Options will be written (sold) on February 9th.
- Commissions, fees and taxes will be ignored because they vary too much from person to person. However, all three should be considered prior to entering into option contracts.
- The current price for shares of Visa is $67.77.
- The cost (premium) of the option contract is determined by the average of the bid/ask spread.
One possibility to enter a position in Visa is using a buy-write strategy. By utilizing the buy-write you simultaneously purchase 100 shares of Visa and sell a call option for whatever strike price you are comfortable with. This saves on commission costs versus doing each move separately. So the up front cost to purchase the shares, excluding commission, would be 100 x $67.77 = $6,777.00.
The following table shows the premiums you could receive based on the average of the bid/ask spread for various call option strike prices.
The "Premium" column in the above table is the amount of cash you would receive upfront. As you can see the Premium decreases as the Strike price increases. The "Premium Return" column shows the percentage return of your original cost, $6,777 to purchase the 100 shares, that you've already invested. That's the return you would receive if the share price is trading below the strike price on the expiration date and the option fails to be executed.
That looks great, but markets and share prices are fluid. Since these are call options and you could potentially have to sell 100 shares of Visa in the future we also have to look at the share price change to determine our return possibilities.
The return profile looks much different once we include the possibility that the call option could be executed. The deep in the money calls, which are more likely to have the share price above the strike and thus executable, offer very little return potential for tying up your capital for nearly one year.
Strike prices that are $75 and higher look like interesting candidates to consider; however, we need to look back at the valuation analysis to determine if it makes sense.
The 2016 earnings estimate is $2.81 per share and the 2017 earnings estimate calls for $3.25 per share. That puts the current price of $67.77 at a 2016 forward P/E ratio of 24.12 and a 2017 forward P/E ratio of 20.85.
In the analysis over the weekend I provided a range of future price targets at varying future P/E ratios. The 2016 price target based on a 25 P/E ratio, what I consider the high end of fair value for Visa given its growth prospects, is $70.25 and for 2017 the target is $81.25. At a 27.5 P/E ratio the 2016 target is $77.28 and the 2017 target is $89.38.
Now we can compare the different strike prices to our price targets to see what combination offers solid returns across an expiration or an execution scenario.
Armed with our price targets and the return possibilities the first strike/premium combination that appears compelling is the $77.50 strike. On expiration date, in this case January 20, 2017, one of two things can happen. If the share price is trading below $77.50 you will keep the premium and the shares. If the share price is trading above $77.50 you will keep the premium, but would likely sell the shares at $77.50.
The reason I find that a compelling scenario is that the returns look adequate if the option just expires. The 5.53% return works out to 5.85% on an annualized basis. Or looking at it another way your cost basis was reduced by the amount of premium you received. For the $77.50 strike call that would be $64.02, a 5.5% discount from Monday's closing price.
If the call option is executed your effective sales price becomes the strike price plus the premium or $77.50 + $3.75 = $81.25. That works out to a 19.89% return in less than a year with an annualized return, excluding dividends, of 21.09%.
If our earnings forecast is correct for both 2016 and 2017, the 2016 trailing P/E ratio would be at least 27.6 and the 2017 forward P/E ratio would be at least 23.9 on the expiration date. I say at least for the P/E ratio because in order for the call option to be executed the share price would have to be at the strike price or higher. At those valuations the shares would be above what I consider to be the high end of fair value for Visa.
As the strike prices increase your return if the option expires decreases, but the total return counting share price appreciation increases.
Selling a call option on Visa could be a great way to set yourself up for a nice return if it expires without execution or really solid returns if it's executed.
There's two downsides to selling call options. One is that you limit your potential gains to the upside by agreeing to sell your shares at the strike price. However, when you account for what would be considered a reasonable valuation based on your due diligence you can pick strike/premium combinations that offer adequate reward for the risk of losing the shares.
The other is that if the share price declines below the strike price less the premium you received you've lost money. I contend though that if your due diligence was solid and the long term thesis and growth prospects of the company haven't changed you should be delighted to collect the premium for free and effectively lowering your cost basis on the shares.
The $77.50 call offers the most attractive return scenarios for my taste based on the current bid/ask spread. Annualized returns of 5.85% if the option expires or 21.09% if the option is executed is a pretty good spot given the current state of the market. Especially when you factor in that the valuation on the expiration date would have shares rather expensive. The $75.00 and $80.00 calls could also be possibilities depending on your desire to generate more income if it expires or more capital gains if it's executed.
Once you've done your due diligence on a company and arrived at a price you're comfortable purchasing shares for, checking the options table could provide a better opportunity than purchasing shares outright.
A full list of my holdings can be found here.
Disclosure: I am/we are long V.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not an investment professional. Investing involves risk and the potential loss of capital. Please consult a financial professional prior to investing and perform your own due diligence. This article is for information/entertainment purposes only and is not meant as investment advice. All charts/images are taken from my own personal stock analysis spreadsheet unless otherwise noted.