Beware of Overpriced Stocks

Today Netflix crashed 13% after lower than expected subscribers were reported for the second quarter. It now trades at $85.63 after falling $13.13. If you had invested in this stock just yesterday you would have lost over 13%. The first thing I do when I see stock headlines like this is pull up the stock and look at it’s P/E ratio. This is currently at an outstanding 266! That’s more than 20 times that of Apple, meaning people have much higher expectations of growth with this stock.

That being said, 266 is better than a P/E of 0 (sometimes denoted ‘-‘), which means that the company does not turn a profit at all. One big example of such a company is Tesla. People are so adamant that Tesla will be the wave of the future that they’ve heavily invested in this stock, which means that Tesla will probably have a high beta. When fluctuations happen you will see these high beta stocks swing much more violently than stable low risk stocks such as Proctor and Gamble, Johnson and Johnson, and utilities. That being said, certain events can still cause ‘stable’ companies to flop or gain/lose an incredible amount of value – buyouts, disasters, shortages are some of these types of events.

In my opinion, I would not consider buying any company with a P/E ratio higher than 100, and would discourage investing in an unprofitable company. If I had to use a stock screener to automatically buy stocks I suppose I would filter by P/E ratio between 10 and 22 with a dividend of between 1 and 3.5% and a return on equity of at least 10%. Return on equity means how much percentage profit each stock generates. For example Apple has in the first quarter had a return on average equity of over 30%, meaning if each dollar of stock generated 30 cents in profits. Not bad! A low return on equity means the profitability of the company based on its equity is low, so more money put into the company might not yield much profit so the incentive for price growth or dividend payouts is probably lower.


What’s a Bull Spread?

A bull spread is a type of call option that aims to profit off of a underlying security that has a specified percent increase. Most of the time investors aim for moderate or low price increase.

An example of a bull spread is to buy a call option for Apple for a expiring three months from now for a strike price of $130 per share. Apple trades at $113.99 as of right now (premarket 12/29/2014). The call option costs $1.37 market price, so for a single option you will be paying $137 (options come in stacks of 100). If you wanted to lower that cost all you’d have to do is sell another call option for Apple for say $140. You’ll get 50 cents for this, so you’ll lower your total cost for this “play” to 87 cents. So pay $87 rather than $137 to make at MOST $10 per share, or $1,000.

I personally am not a fan of the bull spread because of the fact that you’re limiting your winnings, it’s like buying insurance on your winnings. I must prefer having unlimited UPSIDE potential with a put option in place as INSURANCE. Even so, when you’re hedging your investments you are limiting your profit potential.

You can also do what I call a “bear spread” by buying a put option and then selling a put option for a even lower strike price. This would be in anticipation for a moderate downfall in the price of an underlying security. I would personally never do this, it would almost take a wizard or oracle to predict such a price fall to such a degree. You’re better off shorting a stock then paying such hefty premiums for these options.

If you’re interested in seeing what a bull spread looks like on a profit-loss graph here it is below:

Call option March 20 leg 1 buy $130, leg 2 sell $140

Call option March 20 leg 1 buy $130, leg 2 sell $140