There are two primary reasons a stock gets on our Most Dangerous List:
- Misleading earnings: reported GAAP earnings are positive and rising while economic earnings are negative and declining
- Expensive valuation: future cash flow expectations embedded in the current price are unusually high especially compared to historical performance.
In the case of NYSE, the valuation of the stock, when it was put on our MD list on May 1st, predicted that the company would grow its after-tax operating profit (aka NOPAT) by over 11% compounded annually for the next 30 years. I am not sure many companies in the history of the world have achieved such high growth for so long… So, this stock is a great example, like all MD stocks, of bad Risk/Reward. The upside reward is quite small given that the current valuation is already predicting such high cash flows for the future – it is not likely expectations will go much higher. Downside risk is large since the company is not likely to live up to its valuation, i.e. generate the future cash flows its stock price predicts, in fact, our model shows the company’s economic profits are negative and, ergo, it is destroying value. So the stock price could fall quite a bit if/when the market recognizes that instead of 11% CAGR in profits for 30 years straight, there is little to no profit growth.
The takeaway – there are plenty other stocks with better risk/reward to invest in.