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This Unlikely Value Stock Could Yield 16% in One Month

Value investors often look for stocks trading with a price-to-earnings (P/E) ratio below the market average or even in the single digits. They believe that buying when the P/E ratio is low minimizes risks because stock prices will usually not fall too low if the company has earnings. Many of these investors will ignore stocks with high P/E ratios.

High P/E ratios can be a caution flag for investors. In bubbles, P/E ratios often climb above 100 or even 1,000 for some stocks. Unless the company is growing its earnings very quickly, these P/E ratios are usually unsustainable and the stock price often collapses suddenly when investors realize the stock is overvalued.

Then there are times when a high P/E ratio is justified. A company could be in the middle of a turnaround with low earnings over the past 12 months but a promising future. Large accounting charges could lower reported earnings but operating income might be high. In these cases, we might see a triple-digit P/E ratio based on historic earnings but a very reasonable P/E when expected earnings are considered.

Entertainment production company Lions Gate Entertainment (NYSE: LGF) looks like a company with a P/E ratio that is temporarily high, but the stock is a buy based on the forecasts for the next few years.

LGF reported a loss of $0.30 per share in its fiscal year that ended March 2012. Losses have been reported in two of the last four quarters and earnings per share (EPS) have totaled $0.05 over the past 12 months. With a stock price of $18.07 at the time of this writing, the P/E ratio is 361.

For the full year that ends in March 2013, analysts expect EPS of $0.97 and $1.37 the year after that. Based on next year's expected EPS, the P/E ratio is only 13 and LGF looks like a value stock. Analysts expect EPS growth to average 26% a year in the next five years after an average decline of more than 19% a year in the past five years. If they are correct, LGF is a turnaround story.

LGF has been establishing itself as a leading entertainment content creator. The company's movie franchises include "The Hunger Games" and "Twilight." It owns television shows like "Mad Men" and "Anger Management." Altogether, LGF owns the rights to more than 13,000 movies and television shows and is developing additional content all the time. There will be a new "Hunger Games" movie scheduled for release in 2013, and the big hits will likely keep coming.

This content leads to revenue, more than $2.1 billion in the past 12 months, and should deliver earnings. Based on the current price and value, LGF is a buy, but traders wanting to buy at a discount can use a put selling strategy that generates income while waiting for a pullback.

LGF Stock Chart

Put options should only be sold on a stock that you would buy, and LGF appears to be a great long-term buy. Selling a put could allow you to buy the stock at a discount. The February $18 put is selling at about $0.58, or $58 per contract. If LGF is trading below $18 when the options expire, traders who sold puts will have to buy the stock at $18, making the potential cost basis $17.42 (the strike price of the put minus the option premium received).

If LGF is above $18 when the option expires, the profit in the trade will equal the premium received when selling the put. Margin of about $360 (20% of the strike price x 100) will be needed to sell the put because each contract will be for 100 shares of LGF. If the put expires worthless, the potential one-month profit on this trade would be 16% ($58/$360 x 100), or well over 100% a year if we could find a trade like this once a month.

Traders could also consider buying part of the position they'd like to have in LGF now and selling puts to generate income while waiting for a pullback.

Recommended Trade Setups:

-- Buy LGF at the market price
-- Set stop-loss at $16.80
-- Set initial price target at $21.38 for a potential 18.5% gain in 6-12 months

-- Sell LGF Feb 18 Puts at the market price
-- Set stop-loss at $1.20
-- The potential profit is 16% in one month (based on current option prices) if the put expires worthless. If it does not, traders will own LGF at about 12.7 times next year's estimated earnings.

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