"Risked" Casino Gambling With Better-than-House Odds?
Zeev: Very good questions! Let's explicitly take them into account, but at the same time remove the inherent conservatism that I had already built into my numbers due to the below market average PE ratio.
First, as you suggest, we should probably assume that the $2.5 MM in projected profits is not secure, so let's incorporate probabilities for the profit projection to account for this uncertainty. Just to get the ball rolling, I will assume the following...
Profit Projection X Probability of Occurrance:
$2.50 MM X 30%
$2.00 MM X 50%
$1.00 MM X 10%
$0.00 MM X 5%
($0.50 MM) X 5%
----------------
= $1.825 MM (probability-weighted average of future profit projection)
Now that we have an explicitly "risked" profit projection, we can apply a more realistic PE ratio against it to come up with a more realistic "risked" estimate for our profit per share projection. For the lack of any better data, I suggest that we use actual current data from the Stock Smart website for our industry average multiple, but then bump that down a bit to account for the current pricy valuation level of the overall market. EXSO is currently listed on the Stock Smart website under the Personal Products Subindustry (average PE multiple = 24.8X), which is part of the Consumer Products and Services Industry (average PE multiple = 23.5X).
stocksmart.com
Given this actual industry data, but acknowledging the current frothiness of the overall stock market, I would propose that we use a PE multiple of 15X for our "risked" valuation.
Now let's explicitly account for your concerns about future interest charges ($500,000 pre-tax). To do this, simply deduct the after-tax interest charges (remember, debt carries a tax shield) from the "risked" profit projection calculated above:
$1.825 MM - [$0.500 MM X (1 - 40% tax rate)] = $1.525 MM
Now simply substitute these updated "risked" numbers into my original calculations for the breakeven probability required to justify the investment, and you get the following results (all changes in bold):
First, I assumed the following: (1) expected "risked" profit level of $1.525 MM/yr on $42 MM revenue, (2) 50 MM shares outstanding (the maximum currently authorized), and (3) a realistic PE ratio of 15X for the industry.
These assumptions gave me a "risked" earnings forecast of $0.0305/share ($1.525 MM earnings / 50 MM shares), and a reasonable potential stock price of $0.4575/share ($0.0305/share X 15 PE multiple), with a potential upside of almost 5 times the purchase price at today's ask ($0.4575 / $0.09375 = 4.88X or 488% increase). Maximum downside = $0.09375/share (current investment); potential upside = $0.4575/share.
Then I looked at the biggest uncertainty in the equation -- the potential for further equity dilution -- and asked myself if it made any sense to invest at today's price in light of this great uncertainty.
To answer this question, I analyzed the problem mathematically and solved for the minimum probability of additional shares being authorized that would actually yield a breakeven result on the investment (i.e., no gain / no loss). Using simple algebra, I created a formula for the breakeven case and assigned a variable (P) for the breakeven probability.
For example:
0.4575 X P > 0.09375
where P is the probability of the company not having to issue additional shares above the current authorized limit.
Then I solved for P:
P > 0.09375 / 0.4575
P > 20%
This analysis suggests that, in order to justify an investment decision at today's price, you must be confident that the probability of the company not having to issue any additional equity shares must be greater than 20% (a 1-in-5 chance).
As you can see, my more detailed calculations, which account for your concerns about the uncertainty of the profit projections and the interest costs of all anticipated future debt, yield approximately the same result as my more original calculations, primarily because the original calculations had already incorporated a conservative (below-market) PE multiple.
If you disagree with any of the assumptions that I have made, feel free to substitute other assumptions into the above calculations. IMO, unless you dramatically change some of the underlying assumptions, you'll still be looking at a breakeven probability that's less than 50%.
Razor |
