Value investors use a number of filters to identify stocks that have the potential to deliver big gains. The price-to-earnings (P/E) ratio and price-to-sales (P/S) ratio are among the most popular tools. Low ratios are used to find value stocks, and high ratios can be used by traders to find overvalued stocks. When looking for short candidates, the P/S ratio may be the best starting point.
An academic study found that when the P/S ratio of large-cap stocks rises above 12.2, there is an 80% chance the stock will have negative returns in the long term. This study was published at about the same time that Facebook (Nasdaq: FB) went public with a P/S ratio of about 25. FB has been in a downtrend ever since its opening trades, and this simple indicator was offering a warning that FB was unlikely to do well.
A stock in the same sector as Facebook, LinkedIn (NYSE: LNKD), is among the most overvalued stocks in the market right now. LinkedIn offers a popular professional networking website and the company is profitable. However, the stock price seems to have gotten ahead of the company's fundamentals. The stock is trading with a P/S ratio of about 17, and based on next year's earnings, LinkedIn is trading at a P/E ratio of about 87.
The chart shows that the stock could fall significantly, but it would still be overvalued after a big drop. Whether the broad market goes up or down, LinkedIn is a stock almost certain to fall.
LinkedIn has support near $100, which could slow the decline, and a break below that price would confirm a downtrend. With a close under $100, LinkedIn would complete a rounding top pattern that projects a target price of $75. The stochastics indicator has also formed a rounding top-like pattern in overbought territory, and the relative strength of LinkedIn has turned down. These indicators add to the argument for a short position in this stock.
Other traders see the overvaluation and potential in this trade, and that means put options have become expensive, although reasonable profits are still possible. May 2013 $85 put options are trading at about $5.75. If LinkedIn hits its target at $75, these options would be worth at least $10 and the potential profit is 74%.
Buy LinkedIn May 2013 85 Puts at $7 or less. Do not use a stop-loss. Set initial price target at $10 for potential 43%-plus gains in seven months.
Another stock that looks like it could be a good short setup is Alexion Pharmaceuticals (Nasdaq: ALXN), perhaps the most overvalued large-cap stock currently trading when ranked by P/S ratios. This biopharmaceutical company has some promising drugs, but also has a P/S ratio of 23 and a forward P/E ratio of 42. Its rich valuation means the company could fall sharply if it suffers even the slightest misstep in execution.
The chart shows the potential for traders who have short positions in the stock:
Again we see that stochastics has given a sell signal, but the price trend is still up and the relative strength has not signaled a sell yet. As traders, we should always remember that markets can stay irrational longer than we can stay solvent, and therefore wait for a break of the trend line before shorting this stock.
Having moved about 16 points above the trend line, a move of that size below the line would be expected on a break of the trend line, which would happen at about $105. This projects a target of $89.20, for a decline of about 15% after the break.
This is a stock that is very likely to decline over the next 12 months and should be on every trader's watch list. For traders looking for a way to hedge against a general market decline, put options on Alexion Pharmaceuticals may offer relatively inexpensive insurance. January 2013 $100 puts are priced at about $4.35. At the target of $89.20, these puts would be worth at least $10.80, for a potential gain of almost 150%.
Puts on Alexion Pharmaceuticals are a speculative trade, but the stock could be due for a correction at any time and the options are a low-risk approach to profiting from that.
Action to Take --> Buy ALXN Jan 2013 $100 Puts for $5 or less. Do not use a stop-loss. Set initial price target at $10 for potential 100%-plus gains in three months.