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With the stock market struggling to gain ground against a backdrop of trade wars and rising interest rates, it can be argued that many companies are overvalued and ripe for a fall. Even if that turns out to be true, the fact of the matter is that some stocks are more overvalued than others.
Companies that are beating analysts’ expectations are not being rewarded, as witnessed by the 10% decline in Western Digital during the past week after the company posted stellar quarterly results. In that case, all it took was the mere suggestion that its profit margins may compress later this year as prices for its data storage devices “normalize.”
Western Digital is currently priced at only six times this year’s earnings, nearly a third of the multiple for the S&P500 Index. That means a 50% reduction in profits, probably far greater than what the company’s CEO meant to imply by normalization, would still value the company at a substantial discount to the overall market.
That being the case, imagine how bad news from a company that is trading at a premium to the overall market will be treated? If an FPER (forward price to earnings ratio of 6) is considered fair for Western Digital, then there may be a lot of downside risk tech stocks that are overvalued and vulnerable to a big drop at the first hint of disappointing results.
All three of these companies earn the lowest possible score of zero from my IDEAL Stock Rating System, and each of them is scheduled to release their next round of quarterly results later this month. To be clear, each one of those is a solid company that deserves a reasonable valuation. However, all of them appear to be at risk of being repriced downward given the current market sentiment.
GARTNER (NYSE: IT)
We won’t have to wait long to see how first quarter went for Gartner, which is due to release its results on May 8. Although technically classified as being in the ‘Information Technology’ sector, Gartner is really more of a research and consulting business. Its profit margin of 1/10 of 1% provides little (pardon the pun) margin for error, and its forward PER (price to earnings ratio) of 26 is higher than that for Alphabet (NasdaqGS: GOOGL) and twice that of Apple (NasdaqGS: AAPL), companies that actually make a lot of money.
AUTODESK (NASDAQGS: ADSK)
The metrics for software developer Autodesk are even scarier than Gartner’s. It has a negative profit margin of 27% and an FPER of nearly 40 times this year’s earnings. But that’s okay since it grew revenue by an astounding 15% during the previous quarter (sarcasm). Unless it’s getting bought out soon, I just don’t see how Autodesk can maintain this ridiculously high valuation. We may have to wait a couple of weeks to find out, as Autodesk is scheduled to release its Q1 results on May 24.
SYNOPSIS (NYSE: SNPS)
In comparison to other two, software design company Synopsis is a bargain with an FPER of “only” 22 times forward earnings and a profit margin of just under 2%. However, currently valued at more than four times book value and nearly five times sales, Synopsis will need to report blowout numbers on May 25 to keep its share price from taking a dive. Institutions own 93% of all outstanding shares of Synopsis, so only or two of them deciding to get out the stock could create a huge imbalance between supply and decide.
The bottom line is this: All three of these companies appear to be worth less than what the stock market values them for at the moment.
Ring a Put on It
So now that we know who the likely suspects are, how do we make some money off of it? You could short the stock, but that ties up a lot of money and has unlimited risk. A better option (pun intended) is to buy a put option on each of these stocks. For the uninitiated, a put option increases in value when the price of a stock goes down, and the only money at risk is the cost of acquiring the option.
For example, a put option on Gartner that expires on May 18 with a strike price of $120 could be bought on May 2 for about $3. If Gartner drops to $115 by May 18 that option would have an intrinsic value of $5, which represents a 60% return on investment. If Gartner closes above $120 on that date then this option would expire worthless.
Yes, trading options can be a tricky business if you have never done it before, but it’s actually quite simple once you get the hang of it. First, need to get “Level 1” options trading approval from your broker for buying puts, which is easy to do. After that, you simply place your order and off you go.
P.S. If you are not confident about which put options to trade, Investing Daily offers several services that will do that for you including Systematic Wealth, Profit Catalyst Alert and Velocity Trader as explained HERE.