IOI's Analysis of Market Outlook for GE Using a BSM Cone

In this video, I show how to use the online tools at IOITools.com to assess what the market expects as a future stock price range for General Electric. We then compare the market's price range for GE to the valuation range we calculated in an earlier video to assess the possibility of making an investment.

This method is introduced in The Intelligent Option Investor: Applying Value Investing to the World of Options (2014, McGraw-Hill) and in the accompanying online appendices available at IntelligentOptionInvestor.com.

See also the replay of the YCharts conference call on GE as well as the YCharts Focus Report on GE, which you can find on ycharts.com/resources.

A transcript of the video is below.

Introduction

Welcome to the Intelligent Option Investing Video Series. My name is Erik Kobayashi-Solomon, and I am the author of the Intelligent Option Investor.

Today, I’m going to take you through an analysis of GE using the online tools at IOITools.com. In this series of videos, I analyze GE’s valuation drivers, create a valuation range for the company, see what the option market is saying, and look at the leverage of different investment structures.

You’re watching the video showing the creation of a BSM Cone for GE.

Before we dig in, I want to make clear that this presentation should in no way be considered an offer to buy or sell securities. Do be aware, though, that with regards to GE, I am talking my own book.[1]

Here we are at IOI Tools. To get to the BSM Cone Creator, we just go to the Basic Toolkit tab and click on the third menu item.

BSM stands for Black-Scholes Model, and, as I point out in The Intelligent Option Investor, this option pricing model can tell the intelligent investor exactly what future price range the market is forecasting for any stock. In a sense, knowing what the BSM is saying, is like playing cards with someone who always leaves his had face up on the table.

This price is what GE was trading for when I made the original analysis.

Finding the Right Volatility

For the Implied Volatility at the Bid and the Ask, I took a screenshot of the price chain I looked at and posted it here.

Notice that I’m only looking at the call side of the chain, and am focusing in on the November 2014 expiry. In The Intelligent Option Investor, I explain how to read an option chain, so those of you who have read it know why I’m looking at the expiry about three months in the future and for the options that are closest to the 50-delta point in this column here.

In this case, there’s no strike that had a delta value of exactly 50, so I eyeballed the implied vols at the $25 and $26 strikes and decided I would use 14.5% for the bid vol and 14.7% for the ask vol.

Intelligent option investing is not “arbitrage” of very small differences, and I am fine with “eyeballing” things. In my mind, if your investment strategy rests on the difference of a few hundredth of a percent of an implied volatility, you’re doing something wrong.

Now that we have those numbers, let’s go back to the BSM Cone Creator…Where you can see that the values 14.5 and 14.7 are filled in here.

Assessing the Market Outlook for GE

For the Risk-Free Rate, I use the yield on the 30-year Treasury Bond, and take a look at GE’s company page on YCharts to find the dividend yield.

Plugging in these values is all you need to do to see what the market is expecting for a future price of a stock. In the case of GE, the market is expecting the price to range from around $20 to around $33 with a most likely value of about $25.50.

When you are on the IOITools site, you can plug in other values for each of these variables and see for yourself how the market forecast changes.

Value Investing deals with investing when the price of a stock is much different than its value. In this case, I posted a graphic of the prices implied by the option market overlaid on what I calculated to be the best and worst case valuations for this stock.

Because the difference between price—as shown by the BSM Cone here—and value—shown here and in the book as the range between the triangle and the square here—was large, I decided to invest!

Okay, let’s sum up. 

1. The BSM Cone Creator is what allows us to see what hand of cards the market is holding regarding what its expectations are for the future price of a stock.
2. The market is doing something that I think it does a lot: anchoring on recent prices to set its expectation for future ones.
3. The valuation that I did in an earlier video suggests that there is an investment opportunity in GE.

Thanks for joining me for this video. Join me for my next video, where I’ll use the IOI Leverage Analyzer to show you how I thought about structuring my investment in GE.

NOTES: [1]

Disclaimer

Intelligent Option Investor, LLC does not act in the capacity of a Registered Investment Advisor. As such, all information provided herein is for information purposes only and should not be considered as investment advice or a recommendation to purchase or sell any specific security. Security examples featured are samples for presentation purposes and are intended to illustrate how to use methodology explained in The Intelligent Option Investor: Applying Value Investing to the World of Options (2014, McGraw-Hill) in the analysis of the valuation of public securities. While the information presented herein is believed to be reliable, no representations or warranty is made concerning the accuracy of any data presented.

This presentation is not intended as investment advice, nor is it an offer to purchase or sell any specific security.

Disclosure

Mr. Kobayashi-Solomon initiated a beneficial ownership position in the stock and options of General Electric IOI, LLC undertakes no responsibility to update our clients regarding changes in the existence or size of Mr. Kobayashi-Solomon’s investment position in General Electric’s stock or options in the future.