Options for Beginners: Valuation First, Strategy Second

Investing using options is very different from constructing a classic long-term buy-and-hold portfolio. 

In this segment from Motley Fool Live that first aired June 7, Motley Fool Canada analyst Jim Gillies and Fool.com editor/analyst Ellen Bowman discuss the reasons it's important to know the underlying company before you choose an options strategy on a stock.

Jim Gillies: Now, I like being right. I'll fully admit to that ego trip.

Ellen Bowman: You do, don't you?

Gillies: I do.

Bowman: A little bit.

Gillies: But you know what I don't like?

Bowman: Tell me.

Gillies: Losing money.

Bowman: No, I don't like that either.

Gillies: I would rather be right and make money than be right and lose money.

Bowman: I see, so being right was no profit, really doesn't give you much too.

Gillies: Yeah.

Bowman: [laughs] We're not looking for moral victories here, and how we measure the returns at the service too. We look at the end of exploration, how many of these strategies they're profitable? Not where do they go in between, how do they end up?

Gillies: Yeah. To understand a valuation case, you have to put the work in. We're used to putting the work in for any recommendation in any Fool service, I assure you has substantial work behind it more than 1,000 or 2,000 words that are spilled on it to bring a recommendation to members.

Bowman: Absolutely.

Gillies: But you're already doing that work anyway. So put the work into, who do you want to pick on today? We can pick on Starbucks (SBUX -1.02%) today.

Bowman: Let's pick on Starbucks, I hold them. I'm relatively well-informed about that, let's talk about them.

Gillies: Starbucks today is about $112, I think, 111, or 110 bucks a share. I'm hoping for confirmation.

Bowman: Oh, [laughs] sorry, someone on Slido was asking me to type out the rules. So I was doing that actually.

Gillies: Oh, OK.

Bowman: I don't look at my stocks every day. I have no idea what they cost at the minute. Yeah, 111.34. Am I right?

Gillies: Okay, cool. Starbucks, it's a big company, about $130, $135 billion dollars company. It is a company that people visit on a daily basis, a lot of people. Occasionally, I visit on a daily basis when Ontario is not locked down. Lots of small dollar figure transactions, but they're selling an addictive product that people crave daily. It's a good business, a lot of cash flowing through there, but it's not a small business anymore. Well, that will also inform what choices and strategies you'd like to use. It. From a valuation perspective, you could set up a big discounted cash flow model, if you hate yourself.

Bowman: We're not here judge people. [laughs] If that's the thing you feel like doing, then you could.

Gillies: As someone who's set up one of two giant PCF models, that's some few hours I never going to get back, but you want to start getting an appreciation. So if I tell you that Starbucks is trading at six times revenues, but pre-pandemic, it was trading at about 2-3 times revenues for most of that time, you start to say, well, then the question is, how depressed are current revenues that given the higher multiple or is this higher multiple a sign of investor exuberance? There's probably a little bit of both in there. But you start thinking about the valuation and it's like, well, does this thing look 2-3 times revenues again or which is about, I'm just going to eyeball it, 15-20 times EBITDA? Does Starbucks go back there once we have a full reopening, post-pandemic reopening? It's probably reasonable to guess that it will. So you start layering it, what strategy do I want to do?

Again, I'll throw one off here. This is maybe a good covered call strategy or another strategy called a diagonal call might be appropriate here. You would want to pick your strike prices based on what the valuation could be post-pandemic, you like those valuation ratios. You pick your strikes on that. But you wouldn't want to look at Starbucks and pick the most bullish, like this thing is going to shoot the moon. You wouldn't do that with Starbucks because well, like I said earlier, you will have the chance to be right. The stock price might move, but the shoot the moon strategy might end up costing you money rather than making you money. So just be aware of what the value of the company is and that does tend to go back to cash flows. If you look at it, tends to go back to historical ranges where multiples have traded. You want to understand the underlying business before you think options.