A fellow blogger emailed me asking for more details about my “upside” and “downside” analysis. I often discuss those 2 factors when I make stock picks and they are a critical part of my stock analysis. It’s not as easy to explain how I use them compared to other factors such as a P/E ratio for example. I’ll still give it a try today. Basically, I feel like every stock has a profile that can be defined among other things as upside and downside.
I Define Upside As Being…The odds that either a company’s business or the way it is perceived by the market changes in a significant way. There are many different ways and I must judge the probability of each event:
Amazon (NASDAQ:AMZN): I’m a big believer in Amazon and I’ve explained why. The company is taking over ecommerce and dominating new sectors every year. It trades at a high P/E on the hopes that it will eventually focus more on profits and less on increasing market share. If that does end up happening and earnings start to increase, Amazon could end up moving significantly higher. It has a distribution infrastructure unlike anyone else and could easily increase profits at high growth rates.
Apple (NASDAQ:AAPL): Apple has been going through difficult times and the stock is down big over the past 12 months. The company is still profitable, growing revenues and profits and there are rumors that new products are in the pipeline. If ever an Apple TV made its way into Apple shows, it could be very significant to Apple’s bottom line. At its current P/E, Apple could see a major increase. If you’re investing in Apple as a dividend stock, the fact that it has tons of money, and billions coming in every single quarter likely means many more dividend hikes.
I Define Downside As Being: Odds that a company’s stock or business will suffer a significant blow that could mean big losses as a shareholder, there are many examples:
Amazon (NASDAQ:AMZN): As you can imagine, the reason why I’m still on the sidelines on Amazon despite the high upside is the very high downside. It trades at a P/E of 200, has little to no profits and very little growth. Yes, there is that promise of future profits. But if investors start to lose faith in that happening, there is no doubt that the stock could be down BIG. That is scary and I don’t think any Amazon investor could ignore that possibility.
In An Ideal World…
In an ideal world, I’d go for stocks that have high upside and low downside but I rarely see those. When I do, I jump on them and am not afraid to bet a bit more as I did recently going long Apple (NASDAQ:AAPL). What I do however is I try to stay away from trades that have too much downside risk. As much as I like a company like OpenTable (OPEN) and believe in its long term future, there are many types of events (competition from the likes of Google & Facebook, slowing growth, etc) that make the downside risk too significant.
I’m not against taking risk. I am fully aware of the risk involved in holding Facebook () for example but I do think the upside makes the trade worth it. It’s all about balancing both sides.