Research in Motion (RIMM) once traded at high valuation multiples. Adversity struck, and investors ran for the hills. The euphoric investor sentiment which holders had come to rely on as the basis of future returns dried up:
Today, there are several tech companies with valuations which are similarly high. Investors can try hedge their portfolios with put options on these stocks. This strategy assumes that stock valuations eventually regress to typical multiples; that euphoria and bubbles do not last forever.
The following criteria were used to screen high valuation tech stock put candidates:
1) The price-to-earnings ratio is higher than 20 (trailing twelve months).
2) The price-to-sales ratio is higher than 3 (trailing twelve months).
3) There must be an options market for the stock.
Generating a list of Put Candidates
Here is a list of tech stocks which met these criteria:
ARM Holdings plc
Semiconductor - Specialized
Check Point Software
Security Software & Services
Citrix Systems, Inc.
Business Software & Services
Red Hat, Inc.
Diversified Computer Systems
Clearly all of these tech stocks are pricey from a static valuation perspective. We can evaluate them further by using growth estimates and trends to calculate total return for rosy "best case" and a dismal "worst case" scenarios*:
Worst Case (Lower Growth, Lower PE)
Best Case (Higher Growth, High PE)
Inspecting the 3-year total returns under the best case scenario reveals that many of these firms have very rich valuations. In particular, Arm Holdings, Cerner, Check Point Software, Citrix, Red Hat and Teradata would yield annualized losses as high as of 22.7% to investors who bought at today's high prices and sold at a more reasonable 17 PE ratio. These are good firms with great growth prospects, but their current prices are just too high. Losses could be much higher if the future is less bright with lower growth and a market which offers a lower 10 PE ratio.
It is prudent to note that there is no way to tell the future, and that many of these stocks have traded at high multiples for many years and will continue to do so in the future. This is a list of put candidates based on rich valuations, and by no means is a divination or a guarantee about future events.
* Total returns were calculated over a three year holding period for each of these stocks. (I use a 3-year holding period since above-average growth estimates are not reliable further out.) In the rosy "best case" scenario, each stock is assumed to be sold at a generous growth stock price-to-earnings multiple of 17 and the maximum of historical and analyst estimate values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price to earnings ratios, that is, price paid today divided by earnings at the end of the holding period for each stock.
The dismal "worst case" scenario 3-year total returns were calculated using conservative assumptions. A bargain value stock price to earnings multiple of 10 and the lesser of historical and analyst estimates values for earnings growth are assumed.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.