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| Date: Tuesday 02nd 2008f December 2008 02:42:27 PM |
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Evaluating Risk |
| Delta Airlines | 31 Dec 03 | 31 Dec 02 | 31 Dec 01 |
| Operating Income (Loss)000's | (786,000) | (1,309,000) | (1,602,000) |
| Interest Expense 000's | 732,000 | 1,272,000 | 1,216,000 |
| This figure can be obtained at http://finance.yahoo.com/q/is?s=DAL&annual . Delta Airlines is in a big mess. Judging by the three year performance, it reported operating loss for each of the past three years, let alone having enough money to cover interest expense. Operating loss improved somehow but it takes a lot more funding from banks and investors before Delta can pull it through. |
| Those are two characteristics of a stock that possesses the ultimate risk. One way to reduce the risk is to buy a put option. Another way is to completely stay out of it. |
| EPS miscalculation Risk |
| This occurs when the stock of a company that you bought went down and it stays there for considerable amount of time (3-5 years) . Most of the time, the reason is that you miscalculate the value of the company or the company delivers less than expected profit. In the long run, the less profit a company make, the less valuable it is. |
| Let's consider Merck (MRK). Assume that your prediction for EPS is $2.50. 10 yr bond is currently yielding 4.5% and you want MRK to be yielding 7% for taking the extra risks. Therefore, MRK is fairly valued at a P/E of 14, a target price of $35. Current price of MRK is between $25-$30. And you figure you can make between 17-40% return depending on your buy price. |
| A year later, MRK is down to $15. What gives? It turns out that the actual EPS for MRK is $1.75 while 10 yr bond is now yielding 6%. Investors probably want to be compensated around 9% for holding MRK now. Now, MRK is fairly valued at a P/E of 11 with a stock price of $19.25. So here, you not only miscalculate your EPS but interest rate has gone up as well. |
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The ultimate question here is can MRK climb back up to $25? The answer is it depends. As you might have noticed, interest rate plays a part in stock price too. If MRK can earn $2 of EPS while interest rate fall to 3%, then it is quite probable for MRK to climb to $25, possibly more. What if MRK can only earn $1.75 indefinitely? Then, as long as interest rate stays at 6%, MRK's fair value is at $19.25. In this case, you lose 25% of your money due to EPS miscalculation. |
| Calamity Risk |
| This is the risk that is beyond the control of any investors. But it is good to be aware of it. For example, the terrorist attack on September 11th 2001 now causes more firms to spend more money on the safety of their workplace. This added expense means lower EPS projection. Furthermore, the attack may cause investors to demand more return on their money for taking risks. Therefore, if investors used to be satisfied with 3% return above the interest rate, they probably demand 5-6% more now due to the attack. |
| Finally, reducing the risk... |
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After all the risks you incur, you might be wondering if there is a way to reduce your risk. Will that be nice? You are in luck. There are several ways that investors use to hedge themselves against price movement. My favorite is to buy put option on your company. For example, Pfizer Inc. (PFE) is trading at $27.50 recently. You can buy PFE stock and put option expiring at January 06 with a strike price of $27.50 for $2.80 a piece. When the price of PFE falls, the price of your put option will increase. Your downside is limited to the $2.80 you pay for the put option or about 10.2%. |
| The downside of this protection is the time constraint. The $2.80 put option expires after January 2006. Therefore, if you want to 'insure' your stocks for two years, you have to buy another put option expiring on January 2007. However, I do feel that this method is better than losing more money should PFE go to say $15 or $20. |
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