Maximum disadvantage: Each stock has its risk

Have you ever considered what the maximum downside potential is for a stock? In a way, for me it equals the risk we have to take as investors. Although there is not one value that we can specify here.

One stock has a different maximum downside potential than the other. This is partly due to the segment in which it is active. How strong a competitive advantage is. Or whether the general orientation is cyclical. Or not.

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Let’s make some considerations about it today. There is a limit everywhere. The only question is what it is and how far away we are from it at the moment.

Maximum downside potential: The stock and its risk

All this is based on one thing: There is some assessment that most recently the majority of investors say: enough is enough. No matter what I thought in advance, I buy this stock. This is what defines the maximum downside potential. Recently I saw the example of Appleshare, which theoretically would be priced at $ 0.01 with a market value of only $ 200 million. This is, of course, an exaggeration, but it brings us closer to this consideration.

If we think about the maximum downside potential, then what would it be? Usually, and for profitable non-cyclical stocks, I tend to say that over a price-to-earnings ratio of 6, investors should be willing to buy more. At least if there are prospects for solid profits in the future. Not necessarily cyclical, which may fall lower. Or other stocks with other risks.

One difficulty is when it comes to unprofitable stocks. Or growth stocks in general, even if they are profitable. For example, if a company expects a growth in earnings per. share of 10% per annum over the next decade, then, what would be the valuation that underlines the maximum downside potential? I think most recently with a P / E ratio of 10, every investor says: man, I take it. For unprofitable growth stocks, on the other hand, we must use sales and future earnings potential as a benchmark. Here I think: A price-to-sale ratio of 0.4, possibly 0.2 would be a valuation target that would make any investor say: It’s too cheap for me.

Where is this going?

The issue of maximum downside is a final consideration. That means we think about it: what would be the worst case scenario. Basically, there are some exciting stocks that are even heading in that direction. For example, I see Fresenius with a price-to-earnings ratio below 9 as a name moving in that direction.

But there are also stocks breaking out of the ranks. Businesses that have little future potential or little substance can, of course, disappear from the scene. Then 0.00 EUR would be the maximum downside potential. Nevertheless: With some options, it may certainly be a good idea to make these considerations.

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Vincent owns shares in Fresenius. The Motley Fool owns shares in and recommends Apple and recommends Fresenius and the following options: short March 2023 $ 130 call on Apple and long March 2023 $ 120 call on Apple.

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