Using probability to stack the odds in your favor

Welcome to the latest post in my journey to build financial literacy for young adults and their families. In today’s post, I return to sharing the basics of investing with a focus on leveraging probabilities to maximize investment returns in an uncertain world.

As the old (and very obvious) adage goes, you make money by buying low and selling high. In a previous post (https://vocal.media/trader/how-to-buy-low-and-sell-high) I had shared different tools such as a discounted cash flow analysis to get an understanding of a company’s value. This is a critical step in determining if today’s price is high or low. Today, I want to talk about an additional step you can take with your valuation for stacking the odds in your favor when you make “buy low” or “sell high” decisions.

Valuing a company is an attempt to put an estimate as a stake in the ground for what that company’s security is worth. However, as we all know, life is full of uncertainty. The assumptions you use for your model will have a big impact on the valuation derived from that model. As an example, if your estimate for annual revenue growth is too high, all else held equal, your valuation is most likely to be too high. Revenue growth is just one assumption you input into your model. Suppose your assumptions for other variables such as profit margin or cost of debt are also off. The errors in these assumptions all compound and may lead to a wildly inaccurate valuation.

Rather than building one valuation, I recommend building three different valuations:

• A base case with your best-informed assumptions
• An optimistic scenario utilizing the higher parts of the range of your assumptions
• A pessimistic scenario utilizing the lower parts of the range of your assumptions

Here’s how I use these scenarios – let’s use the example of my interest in buying a hypothetical stock as an illustration:

• I start with my base case valuation. If the stock price today is above that number, then we are in the “high” scenario where I wouldn’t want to buy it. If the stock price is lower than the valuation, then I’m interested. For today’s example, let’s assume my base case valuation is $30 and the stock is $25 so I’m interested in buying as the base case is for a gain of 20% ($30 base case valuation - $25 starting price = $5 which is 20% of the $25 starting price)
• Next, I look at the differences between today’s stock price and each of the optimistic and pessimistic scenarios. For today’s example, let’s assume the following:

1. Optimistic valuation is $55 so the difference from today’s price and that scenario is $30 ($55 optimistic valuation - $25 starting price = $30 gain). If this scenario materialized, I’d have a 120% gain ($30 gain = 120% of the $25 starting price)
2. Pessimistic valuation is $20 so the difference from today’s price and that scenario is -$5 ($20 pessimistic valuation - $25 starting price = -$5 loss). If this scenario materialized, I’d have a 20% loss (-$5 loss = -20% of the $25 starting price)

• Then I would look at the ratio of potential gain in the optimistic scenario vs. loss in the pessimistic scenario. In this case, it’s a 6:1 ratio of gain vs. loss (120%: -20%)

This gives me a simple way to look across the universe of opportunities I have to buy stocks. Naturally, I want to have as high a base gain as possible. However, I also want to stack the odds in my favor by having as high a ratio of gain to loss as possible. To find that best combination, I typically use a 2x2 matrix which has base gain on the y-axis and ratio of gain to loss on the x-axis

1. Quadrant 1: High base gain + ratio of gain:loss greater than 1
2. Quadrant 2: Low base gain + ratio of gain:loss greater than 1
3. Quadrant 3: Low base gain + ratio of gain:loss less than 1
4. Quadrant 4: High base gain + ratio of gain:loss less than 1

I ideally want to focus on those securities which are further up and to the right on the 2x2 matrix (Quadrant 1) – these are the stocks which provide a happy medium of good predicted base gains with a high likelihood of having a gain. Using this simple methodology should help take your valuations one step further and stack the odds in your favor when making “buy low” or “sell high” decisions.

Thank you again for joining me on my journey to build financial literacy for young adults and their families. If you are interested in reading more of my posts, please access my author page (https://vocal.media/authors/sudhir-sahay) where you can see all the posts I’ve published. If you have any questions on today’s post of if there are any topics you’re interested in my broaching in future posts, please let me know. I can be reached at [email protected].