WHAT WE DO? WE SELL OPTIONS FOR INCOME. WE USE THAT INCOME TO BUY DIVIDEND GROWTH STOCKS!
CHECK OUR TRADES ON OUR MeWe PAGE!


How to buy great companies that are expensive: Valuation still matter

Many investors these days forgot valuations and started chasing companies that have no revenue, no income, and that are burning cash every quarter. Yet they are hot and their prices are skyrocketing.

There are plenty of companies that are great and valuable but they trade at a premium to their intrinsic value. For many years I argued that if you look for valuations and buy only undervalued companies then there will be certain stocks that you would never be able to buy or you would have to wait for 10 or more years for a major market crash that would make these companies valued properly.

One example can be Coca Cola (KO). A great business. I love the stock and I want it in my portfolio. But that company is terribly overvalued. Since the 2008 crash, it always traded at a premium to its value:
 

Coca Cola
 

Another example in this category of great but overvalued companies is Apple (AAPL). For many years, AAPL traded near its intrinsic value, tracking it closely. Until September 2019. That month, the stock skyrocketed and continued rallying since then. Even a 40% crash of the market in March 2020 didn’t correct the stock valuation.
 

Apple
 

And it may take years for this stock to drop. And it may never drop. It may start trading sideways for many years until the valuation catches up with the price of the stock. And you (and I) will be sitting on the sidelines for years.

If you are like me, you want these companies. I want them. I want to own AAPL and AMZN, or SNOW. But how do you buy them so you don’t burn your cash that may be lost in the future if the market finally corrects?

The secret is in the cost basis. If I can lower the cost basis of the stock, it is like buying it cheaper.

There are a few investors I have seen who do not believe in cost basis and its lowering. They say it is an artificial maneuver and in reality, you do not lower your cost basis at all. But that is a way of the view you are looking at income and cost basis of a stock.

Some people view dividends and other income generated by the stock or your trading as an income that is added on top of your capital gains. Others use the income and subtract it from a purchase price, refer to a book “Generate Thousands in Cash on your Stocks Before Buying or Selling Them” by Samir Elias. I am in that category. I believe, that if you can manage that the stock returns all your invested dollars back to you (as Warren Buffett also looks for in his investments), you end up owning the stock for free.

What income can help you to lower the cost basis?

  1. dividends
  2. options premiums

And so, I started to track my desired cost basis and adjusted my prices to take into account options premiums to lower my cost basis.
 

Stock cost basis
 

Now I can see my income adjusted cost basis of a stock and compare it to my intrinsic value of a stock. My goal is now to keep reducing the cost basis until I reach the minimum (or go significantly below it). For example, AAPL is trading for $135.39 a share. My unadjusted cost basis is $130.95 per share but my income adjusted cost basis is $122.49 a share. However, I need to lower it to $60.14 a share.

For that reason, I will keep selling options and collect premiums to further lower my cost basis. Then, when my cost basis will be below the intrinsic value of a stock, I can be buying expensive stocks and not worry about valuations.





Leave a Reply

Your email address will not be published. Required fields are marked *