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10 Options Market Picks Undervalued by the Graham Number

Posted
11/8/2011 8:27:00 PM
By: Kapitall
Referenced Stocks:INDB;NSIT;PRSP;SMS;SYX;TNDM;WBS;TTMI;WRB;ZINC

(Written by Alexander Crawford. Options data sourced from Schaeffer’s, BVPS and EPS data sourced from Yahoo! Finance.)

Value investors look for stocks that they believe are trading below their fair value. If they bet correctly, the stock may soon rise to its fair value, generating a profit.

In the search for potentially undervalued stocks, one idea comes from the “godfather of value investing,” Benjamin Graham. Graham was a professor at Columbia Business School who mentored Warren Buffett and wrote several fundamental books on stock analysis.

The Graham Number

Graham created an equation that calculates the fair value of stocks based on two fundamental data points: current earnings per share and current book value per share.
The Graham Number = Square Root of (22.5) x (TTM Earnings per Share) x (MRQ Book Value per Share).

This equation assumes that a stock is overvalued if P/E is over 15 or P/BV is over 1.5, and any stocks trading at significant discounts to their Graham number are considered undervalued by the equation. But in choosing stocks, it helps to analyze them beyond their valuations.

Options Sentiment

Another important angle in stock analysis is market sentiment. Are knowledgeable investors optimistic about a company’s outlook? Would you be betting with or against the crowd?

A great guide for sentiment comes from the options market, in which changes in the ratio of outstanding put options to call options (the “put/call”) on a stock can indicate whether options traders are becoming more bullish or bearish.

To demonstrate these ideas, we ran a screen on stocks trading at significant discounts to their Graham number that also have seen bullish decreases in put/call over the last ten trading days.

Do you think options traders believe these names are undervalued?

Use this list as a starting point for your own analysis.

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List sorted by change in put/call ratio.

1. Sims Metal Management Limited (SMS): Operates in the metal recycling industry. The stock's put/call ratio changed from 3.54 to 0.13 over the last two weeks, a bullish change of -96.33%. Diluted TTM earnings per share at 0.98, and a MRQ book value per share value at 15.22, implies a Graham Number fair value = sqrt(22.5*0.98*15.22) = $18.32. Based on the stock's price at $13.92, this implies a potential upside of 31.6% from current levels.

2. Prosperity Bancshares Inc. (PRSP): Operates as the holding company for Prosperity Bank that provides retail and commercial banking services to small and medium-sized businesses and consumers. The stock's put/call ratio changed from 4.23 to 0.18 over the last two weeks, a bullish change of -95.74%. Diluted TTM earnings per share at 2.94, and a MRQ book value per share value at 32.87, implies a Graham Number fair value = sqrt(22.5*2.94*32.87) = $46.63. Based on the stock's price at $37.89, this implies a potential upside of 23.07% from current levels.

3. Horsehead Holding Corp. (ZINC): Produces and sells specialty zinc and zinc-based products in North America. The stock's put/call ratio changed from 4.18 to 0.21 over the last two weeks, a bullish change of -94.98%. Diluted TTM earnings per share at 0.53, and a MRQ book value per share value at 8.78, implies a Graham Number fair value = sqrt(22.5*0.53*8.78) = $10.23. Based on the stock's price at $8.8, this implies a potential upside of 16.28% from current levels.

4. Insight Enterprises Inc. (NSIT): Provides information technology (IT) hardware, software, and service solutions to businesses and public sector clients. The stock's put/call ratio changed from 1.81 to 0.17 over the last two weeks, a bullish change of -90.61%. Diluted TTM earnings per share at 1.87, and a MRQ book value per share value at 12.9, implies a Graham Number fair value = sqrt(22.5*1.87*12.9) = $23.30. Based on the stock's price at $17.09, this implies a potential upside of 36.32% from current levels.

5. Independent Bank Corp. (INDB): Operates as the bank holding company for Rockland Trust Company that provides commercial and retail banking, and wealth management services in Massachusetts. The stock's put/call ratio changed from 2.98 to 0.29 over the last two weeks, a bullish change of -90.27%. Diluted TTM earnings per share at 2.15, and a MRQ book value per share value at 21.48, implies a Graham Number fair value = sqrt(22.5*2.15*21.48) = $32.23. Based on the stock's price at $25.63, this implies a potential upside of 25.77% from current levels.

6. W.R. Berkley Corporation (WRB): Operates as commercial lines writers in the property casualty insurance business primarily in the United States. The stock's put/call ratio changed from 0.27 to 0.03 over the last two weeks, a bullish change of -88.89%. Diluted TTM earnings per share at 2.75, and a MRQ book value per share value at 27.77, implies a Graham Number fair value = sqrt(22.5*2.75*27.77) = $41.45. Based on the stock's price at $34.5, this implies a potential upside of 20.15% from current levels.

7. Neutral Tandem, Inc. (TNDM): Provides voice, Internet protocol (IP) transit, and Ethernet telecommunications services worldwide. The stock's put/call ratio changed from 0.25 to 0.03 over the last two weeks, a bullish change of -88.0%. Diluted TTM earnings per share at 0.91, and a MRQ book value per share value at 8.02, implies a Graham Number fair value = sqrt(22.5*0.91*8.02) = $12.81. Based on the stock's price at $10.51, this implies a potential upside of 21.93% from current levels.

8. Systemax Inc. (SYX): Operates as a direct marketer of brand name and private label products. The stock's put/call ratio changed from 0.31 to 0.06 over the last two weeks, a bullish change of -80.65%. Diluted TTM earnings per share at 1.35, and a MRQ book value per share value at 11.99, implies a Graham Number fair value = sqrt(22.5*1.35*11.99) = $19.08. Based on the stock's price at $14.23, this implies a potential upside of 34.11% from current levels.

9. Webster Financial Corp. (WBS): Operates as the holding company for the Webster Bank that provides various banking and financial products and services in southern New England and eastern New York State. The stock's put/call ratio changed from 1.37 to 0.27 over the last two weeks, a bullish change of -80.29%. Diluted TTM earnings per share at 1.48, and a MRQ book value per share value at 21.03, implies a Graham Number fair value = sqrt(22.5*1.48*21.03) = $26.46. Based on the stock's price at $19.54, this implies a potential upside of 35.43% from current levels.

10. TTM Technologies Inc. (TTMI): Provides backplane and sub-system assembly services in the United States and internationally. The stock's put/call ratio changed from 0.8 to 0.18 over the last two weeks, a bullish change of -77.50%. Diluted TTM earnings per share at 0.84, and a MRQ book value per share value at 9.33, implies a Graham Number fair value = sqrt(22.5*0.84*9.33) = $13.28. Based on the stock's price at $10.86, this implies a potential upside of 22.28% from current levels.