When was the last time you bought a stock on the strength of a hunch?
We all do it: you get excited about a story and, although you have a few nagging doubts, your instincts tell you to just go with it.
In my early years as an investor I often just winged it especially if I was taking a punt on an exciting mining or drug stock.
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But relying on gut instinct is dangerous when it comes to investing. Most of our instincts evolved to help us deal with the perils of the hunter-gatherer environment. They don't always work in the circus of the stock market.
What you need is a technique that allows you to rationally assess your instincts. And I have one for you today.
You can use this technique with any stock, and practically any type of meaningful decision you need to make in life.
Sounds great? Let me show you what I mean with a stock I've got a close eye on right now Sportingbet (SBT).
The online bookie is currently the subject of a takeover bid by Ladbrokes, and at its current price, I reckon there should be a good profit in there for you. The stock is trading at 52p, and a bid could come in at 80p or more. That's got to be well worth a look!
Table your thoughts to see things clearly
Though I say a bid could come in at over 80p, in reality, the markets don't know what price the bid will be at. Frankly, Ladbrokes may give up and not even put in a bid. Its recently aborted takeover of another online bookie, 888, is proof of that.
I don't know what's going to happen. But that isn't going to stop me making an assessment.
To start with, I write down the various scenarios that could play out from here.
Here's the way I see it:
1. No bid materialises and SBT drops below where it was before Ladbrokes showed up. The fall reflects market conditions since the potential bid was announced.
2. No bid materialises and the SBT share price falls back to roughly where it was trading before the offer. The very fact that there's been a bid shows that there's some value in SBT that wasn't recognised by the market.
3. No bid materialises, yet SBT continues its growth strategy and the stock reaches back to its recent highs over the coming year.
4. SBT accepts a low bid from Ladbrokes.
5. SBT accepts a mid-range bid.
6. SBT accepts a knock-out bid from Ladbrokes
Once you've identified your key scenarios, now comes the good bit. This is where you table your gut instincts about the chances of each scenario happening.
We need two things. First, the likelihood of each scenario happening. And then, the price you'd expect the share to trade at in each scenario.
All right. You may say that you've got no idea about any of this information. Fine. But as an investor, that's what you're paid to do you need to make a risk-adjusted decision based on unclear and unknowable information.
And whether you realise it or not, every time you make an investment decision, your brain is computing this for you. All I want to do is make things a little easier on your brain.
So, for each scenario I've put in the share price and the chances of it happening. Then I've simply multiplied the two things together to give me a weighting for each scenario.
The final step is to add up all the weightings, and hey presto. You've arrived at your risk-adjusted, fair value. And it's all based on your personal analysis.
My fair value calculation for Sportingbet
|No bid, share price fall below pre-bid
|No bid, share price fall to pre-bid
|No bid, share price rise above pre-bid
|Low bid accepted
|Mid-range bid accepted
|High bid accepted
|Row 6 - Cell 0
|Row 6 - Cell 2
So for me, I've arrived at a fair value price of 60.75p. And given that I can buy shares in the market for 52p, I reckon there's upside potential here.
This approach is particularly useful as you can adjust the table as the game plays out.
For instance, a couple of weeks ago Sportingbet announced that it is in exclusive talks to sell its Turkish business. That's significant. Ladbrokes won't want the Turkish business as it's not operating in a regulated market. Basically, Ladbrokes has got too much to lose if it takes over Sportingbet while it's holding the Turkish business. If the authorities clamp down on this operation in the future, Ladbrokes could lose its reputation and face significant fines.
So Sportingbet is hiving it off and clearing the decks for a takeover. This signals the fact that Sportingbet is serious about this bid. When I heard the news, I adjusted the weightings on my table. Though the share price went up, my risk-adjusted price went up even further.
Making these sorts of adjustments is nigh on impossible if you haven't tabled your thoughts in the first place.
I use a spreadsheet for my tables, as I find that easiest. If you don't know how to use a spreadsheet, then the chances are you are of an age where you can do the maths in your head. I'll leave that up to you.
In this example, I've used six outcomes for my table. You could use more, or fewer; you just use the same idea. Just make sure that all your percentages add up to 100% and you won't go wrong.
Why not try doing the same exercise for the gold price? See what scenarios and valuation you come up with.
This article is taken from the free investment email The Right side. Sign up to The Right Side here.
Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Frank Hemsley. The Right Side is issued by MoneyWeek Ltd.
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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.
He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.
Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.
Bengt also writes our free email, The Right Side, an aid for free-thinkers on how to make money across financial markets.
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