Poor Odds For Virgin Galactic Bulls
Summary
- Wall Street analysts are bullish on SPCE.
- Annualized implied volatility is extremely high (97%).
- Market-implied (aka option-implied) skewness is extremely high.
- The market-implied outlook is bearish.
- Even with high expected return, I'm bearish overall.
Commercial space transport may indeed be the future, but we don't yet know what that looks like. Setting expectations of how quickly the company can provide viable revenue is fraught with massive uncertainty. Even so, analysts have been setting aggressive price targets. On March 3rd, a Bank of America analyst reiterated a buy rating on Virgin Galactic (NYSE:SPCE) and set a price target of $50. On March 16th, Truist initiated coverage on SPCE with a buy rating and a price target of $50. The current share price is $29.24.
Price history and basic stats for SPCE (Source: Seeking Alpha)
The price of a stock is supposed to reflect the net present value of the future earnings of the company. Based on the volatility of SPCE, it is fair to say that the market has no confidence in estimating the future earnings stream. The stock ended 2020 at $23.73, climbed to a high close of $59.41 on February 11, 2021, and is now trading at $29.24. Even with the recent decline, the stock is up almost 115% over the past 12 months.
I am not going to opine on the probability of successful future test flights and how soon the company will be flying tourists into space. I am going to discuss the implications of two different consensus outlooks on the stock. The first is the Wall Street analyst consensus outlook. The second is the market-implied outlook (aka option-implied outlook) derived from the prices of call and put options trading on the stock. There is a very active options trade on SPCE, which makes the market-implied outlook especially interesting.
Wall Street Analyst Outlook
eTrade's consensus outlook combines the views of 9 ranked analysts who have provided ratings and price targets over the past 90 days. The consensus rating is bullish and the consensus 12-month price target is $37.67, 29.3% above the current price.
The dispersion in the analyst outlooks is very high and this tends to be a warning sign. A 2019 study found that high dispersion in analyst price targets tends to predict a negative correlation between the implied return from the consensus price target and the subsequent realized return. In this case, the price target implied a high positive return, but the high dispersion would tend to suggest that the most probable realized return is negative.
Wall Street analyst consensus rating and 12-month price target for SPCE (Source: eTrade)
Seeking Alpha's Wall Street analyst consensus combines the view of 8 analysts, yielding a consensus bullish rating and a price target of $38.25, which is 31.5% above the current price. None of the 8 analysts give SPCE anything below a neutral rating.
Wall Street analyst consensus rating and price target for SPCE (Source: Seeking Alpha)
Market-Implied Outlook
The market-implied outlook for a stock is derived from analyzing the prices at which call and put options on that stock are trading. An option is a bet on the probability that the price of the stock will rise above (call) or fall below (put) a specific level (the strike price) over a period of time (from now until the expiration date). By combining the prices of calls and puts at different strikes but the same expiration date, it is possible to calculate the probabilities of all possible returns that would reconcile the options prices.
This concept is fairly widely studied in quantitative finance. For those who are unfamiliar, I have written an overview post that provides examples and links to the finance literature and an implementation by the Minneapolis Federal Reserve Bank. I have used my own implementation of the market-implied outlook in a growing body of posts here at Seeking Alpha, too.
I have analyzed options on SPCE that expire on January 21, 2022, providing a probabilistic outlook of price returns between now and that date, the next 9.5 months. The standard presentation of the market-implied outlook is a probability distribution, with probability on the vertical axis and return on the horizontal axis, going from the most negative return on the left side to most positive on the right.
Market-implied price return probabilities for SPCE for the period from today until January 21, 2022 (Source: author's calculations using options quotes from eTrade)
The market-implied (aka option-implied) outlook for SPCE is bearish, with a wide range of the most probable outcomes being negative returns over the next 9.5 months. The single most probable outcome (the peak in probability on the chart) is a price return of -37.5% over this period. What is quite unusual about this case is that there is a secondary peak in probability corresponding to a -100% return (on the far left side of the chart). There is also a very long positive tail on this distribution, with low but non-vanishing probabilities of price returns of 200% and higher over the next 9.5 months. The market-implied distribution of returns is extremely positively skewed.
The secondary peak at -100% means that the put options are sufficiently expensive that they suggest a decent probability of the company going out of business. The market-implied outlook was formed using options with strikes ranging from 57% below the current price to 54% above the current price. This emphasizes the more likely outcomes, but also means that there is less confidence in estimating the extreme tails. Because of the thin options trading at extreme tails, the estimates would be of marginal confidence even if the analysis focused on these.
The annualized volatility for SPCE derived from the market-implied outlook is 97%. This is extremely high. For comparison, the annualized volatility I calculated for Snowflake (SNOW) in the same type of analysis was 62%.
To understand the market-implied outlook, it is often useful to examine the percentiles of the market-implied probability distribution (below). The percentiles indicate the probability of the price return being above or below a specific level over the 9.5-month period.
Percentiles of market-implied price return probabilities for SPCE for the period from today until January 21, 2022 (Source: author's calculations using options quotes from eTrade)
This is a fairly remarkable percentile chart for an individual stock due to the extreme skewness in the market-implied outlook. There is a 69% estimated probability that the price return will be less than or equal to zero over the next 9.5 months (the 69th percentile value is where the percentile curve crosses from negative to positive). The median return (the 50th percentile) is -34% for this period.
This percentile chart is a more extreme version of what I got when I analyzed Snowflake in early March.
Summary
SPCE is a perfect case to raise the question of whether buy/sell/hold types of ratings are relevant for certain stocks. An analyst's price target is his or her estimate of expected value. The problem is that the advisability of betting on a stock (or anything else) depends very much on the distribution of outcomes around the expected value. Even if the analysts are correct in their bullish outlook, it is a bad idea to invest in a stock like SPCE based on expected value without accounting for the skewness.
While SPCE is an extreme case, there are many other stocks that have market-implied outlooks with substantial positive skewness. These are often companies with high and relatively predictable potential growth, such as Teladoc (TDOC). The statistical reality, however, is that even if the expected value of the outcome is very high, rational investors will discount that expectation if the skewness is also very high.
Unfortunately for investors who favor high skewness bets, there is a body of research that shows that stocks with high skewness underperform, even after accounting for all other known factors.
While there is some chance that SPCE will deliver huge positive returns between now and early next year, there is a far larger probability that the returns will be substantially negative. Even if the bulls are correct, investing in SPCE reminds of a classic problem in game theory called the St. Petersburg Paradox. When a bet has extreme positive skewness, rational gamblers are very reticent to play. My final rating on SPCE is bearish, even as I understand that the long-term expected value may be huge.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
Recommended For You
Comments (33)
At current levels ($28-$30) it a coin flip, all predicated on SPCE getting to space.
