Got the following question from a reader: “I was wondering, how does one go about calculating upside potential?”
The answer to this question is really a two-part one. Firstly, you should realize that there is no real way to calculate upside. That is the beauty of investing, and wealth.
Wealth is not a zero sum game. The potential is literally limitless. It is because of this reason why the stock market can be so beautiful. People can dream for the stars and reach them.
A stock could double, but it could also gain 1,000%. Depending on the size of the stock and the growth of the company’s profits, you could see a company make fascinating gains over many years.
This is another reason why short selling is so dangerous (and counterproductive in most cases). Not only is time fighting against you, you’ll have to pay out dividends instead of receive them, but the risk/reward advantage that you should’ve had as a long term investor is reversed.
A short seller has infinite loss potential and only a 100% gain potential. Because of the infinite upside of stocks, a short seller is forced to use leverage in case of a stock run-up. Therefore, he could lose much more than he initially invested.
Contrast that to the average long term investment. The most you can lose on a stock is 100%, but the most you can gain is much more than 100%. Again this is why stocks are so attractive and useful as a tool for building wealth.
You can’t calculate future upside any more than you can calculate what the exact temperature will be in 3 months, or who the Super Bowl winner will be next year, or what fashion trend is going to explode in 2020, or even which video will go viral next.
Sure there are calculations to be made that will help our probabilities, it isn’t all helpless. But to say that one stock has more upside than other… in most cases, that’s a foolish thing to say.
Depending on the Context…
I’ll add though that it also depends on the context of the conversation. For instance, I’ll say with complete confidence that Stock A with a P/E of 15 and Debt to Equity below 0.5 has far better upside than Stock B with negative earnings and a Debt to Equity of 10.
Also, I’ll add that a stock with a market capitalization of $2 billion has more likely upside than a stock with a market capitalization of $700 billion. It’s not that I don’t think the bigger company isn’t fantastic, but it just doesn’t have as good a chance of doubling as the smaller $2 billion stock.
All that being considered, it’s hard if not impossible to calculate which of my stocks in a portfolio has the most upside. Knowing that I test rigorously and have taken the precautions to find a conservatively run company with high profitability, the rest is out of my hands. I don’t know which stock will be my big winner, but I know that over time and with enough stocks I’ll do real well.
Here’s some important financial ratios that will help you find higher upside risk… by giving you a buy point that is more attractive than the average.
Earnings are the name of the game. When investing you need to know that you are getting enough earnings for your buck, which will turn into cash for the shareholders (you). Learn this with the P/E ratio.
Intrinsic Value of the Company
The intrinsic value is referring to the company’s assets and liabilities, and this is how business owners value a business. If you can get even $1 of assets for each $1 you invest, the downside of this investment becomes minimal. Learn how much you are paying for these assets with the P/B ratio.
If a company isn’t making revenue, then they sure aren’t going to be making profits. Earning are more volatile than revenue, and so this category is very useful in volatile time periods. Use the P/S ratio in this case.
Cash, and Utilization of Excess Cash
You want part of the company’s profits, and companies with more cash are able to pay you more. You want companies to pay you cash, but not to pay too much that it puts the company in jeopardy. To figure out these things, you’ll want to familiarize yourself with the P/C ratio, payout ratio, and dividend yield.
This category should be obvious to why it’s so important, yet it’s often overlooked. So many companies have gone under because of the burden of too much debt, and you want companies with as little debt as possible. The Debt to Equity ratio is the great equalizer, as a company can look like it’s in great shape with all the other ratios but lack in this one, ending badly for investors.
Common Pitfalls When Using These Ratios
Great, so I learned about one ratio like the P/E ratio. I can just use this one when picking stocks and I’ll be fine right? No you’re wrong. While knowing about one ratio will help you out tremendously, there are some other things you must consider.
Every ratio, P/E ratio especially, varies depending on the sector. Automotive companies like Ford (F) tend to have much lower P/E ratios than technology companies like Microsoft (MSFT). A P/E of 15 would be great for a technology company but not so great for an automotive company.
This is why I always stress looking at multiple categories. And I’ve narrowed it down so all your bases are covered.
The amazing thing is that the differences in sectors will cancel each other out. A company who has a low P/E ratio because they manufacture cars will consequently have a much higher debt to equity ratio than a technology company.
It makes sense if you look at it this way. An automotive company needs much more capital to build factories and hire workers than a technology company does. The technology company doesn’t have as many expenses, and therefore will have much lower liabilities.
Lower liabilities correlates with a lower debt to equity ratio, which is very desirable. But these technology companies tend to earn less profits than a business with more concrete assets, and so their P/E ratios are very high.
As you can see, a technology company’s biggest advantage, needing less money to operate, is also its biggest disadvantage. The company will have less debt but also less ability to generate earnings as easily.
There are many of these variations when looking at ratios. But as you can see, you don’t have to worry about these subtleties as long as you are looking at a broad enough range of categories.
I teach about the important categories you need to consider, nothing more and nothing less. It may seem overwhelming at first, but if you can master my 7 steps you will know everything you need to fully analyze companies and stocks.
A Problem w/ Upside Potential
The second part of this answer is that many investors do calculate upside potential. In fact, I see value investors do it all the time.
What some value investors do is find stocks that are trading below their intrinsic value and then sell the stock when its value aligns with the intrinsic. Effectively, they will see upside potential as equivalent to the discount below intrinsic value. Meaning… a stock that is trading at 60% below its intrinsic value has a 60% upside potential.
This thought process, while popular, can be extremely detrimental in my opinion. For starters, not every stock is going to trade at its intrinsic value. Many times it never does catch up. The market doesn’t care about your equations, and your equations and analysis may be completely off base. Something that investors don’t like to admit, but it’s more likely than they believe.
The even worse scenario could be that the stock does reach its intrinsic value. By selling at this intrinsic value, you are again destroying your risk/reward advantage. You are essentially capping the upside by always selling at this point, and the stock could very well continue to climb.
Many times it does. As a fellow value investor myself, I understand how easy it can be to forget about the power of momentum. It can be easy to become “too contrarian” and shoot yourself in the foot. Stocks that rise tend to continue to rise. Not always, but a lot of the time.
And so why would you kill off your best investment just as it is catching steam? I’ve seen so many stocks that have doubled or tripled after their value was long restored. They just keep going and going and going. Why would you ever want to stop that?
You are buying stocks as a part business owner. When the stock price corresponds with increased earnings, don’t get cute. Just tell your money to stay put.
After all, you don’t know what tomorrow brings. I sure don’t. But you want a philosophy of cutting your losers and letting your winners ride. It brings you unlimited reward / limited risk. It’s your big advantage. Use it.
This is really why I don’t calculate upside potential, and don’t care to.