Prophet of profits (The Financial Athlete #86)

Sports fans are good at predicting who will win or lose a game. They evaluate win-loss records, match-ups, home court (or field) advantage, and statistics.

Good predictions are based on observation, experience, and reason. A smart investor examines visibility of future earnings and cash flow to predict the future of the stock price.

Investing gets very interesting when a “catalyst” potentially enters the equation. In chemistry, a catalyst is a substance which causes a chemical reaction to occur at a much faster rate. For stocks, a “catalyst” is an event which would thrust the stock price upward.

Investors should use simple probability analysis to decide whether to hold or sell when a potential catalyst influences the stock price.

Suppose the catalyst is a widespread rumor of a buyout from a well-known and large publicly-held company.

Rumored buyout price: $15.00/share
Market price before rumor: $8.00/share
Market price after rumor: $11.00/share
Therefore, the market’s estimated probability of buyout (“catalyst”) is 73%.

You estimate the probability of a buyout at 60%. So, your calculated price is $9.00/share (0.60 x $15.00). In this case, it would be better to sell the stock at the market price of $11/share, which is a $2.00 more per share than your calculated price, rather than wait and hope for a buyout at $15.00/share. Remember, if the buyout doesn’t happen, the market price should return to the price range before the rumor of the buyout ($8.00/share) or lower. The price may trade lower than $8.00/share due to disappointment in management’s failure to close the deal.

Photos: Jamaica’s Usain Bolt entered the 2008 Summer Olympics as the favorite to win the 100 meters and 200 meters dash. No one was surprised he took the gold for both events, the first since Carl Lewis in 1984.

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