Valuation Models Applied to LEAPs

LEAPs without valuation is speculation with a fancy name. The only reason leverage works for value investors is because we start with the fundamentals, not the trade. Before you ever think about strike prices or expiration dates, you need to know what the business is actually worth. Wall St Yardie uses three core models, discounted growth, cap rate, and payback time. Here's how each one guides your LEAP decisions.

TL;DR

• Valuation comes first, LEAPs come second: Never buy a LEAP until you know intrinsic value and margin of safety
• Discounted growth model: Estimates future cash flows, tells you if the stock is undervalued by 20-40% (the sweet spot for LEAPs)
• Cap rate thinking: Treats the stock like real estate, comparing earnings yield to alternative investments, helps you pick strike prices
• Payback time: Shows how long it takes earnings to repay your investment, guides whether LEAPs are worth the time decay cost
• All three models must agree: If one says undervalued and two say fairly valued, skip the LEAP and stick to stock ownership

Why Valuation Models Matter for LEAPs

Stock buyers can afford to be patient. If the market takes 5 years to recognize a company's value, they keep collecting dividends and compounding. LEAP buyers don't have that luxury. Your contract expires in 18-24 months. If the market doesn't move in that window, you lose the premium.

That's why valuation must be solid before you add leverage. You need:

1. Undervaluation: The stock should trade 20-40% below intrinsic value to justify the risk
2. Catalysts: Something should push the stock toward fair value within your LEAP timeline (earnings growth, buybacks, industry tailwinds)
3. Margin of safety: Even with leverage, you need a buffer in case your estimate is slightly off

Wall St Yardie uses three models to cross-check valuation: discounted growth, cap rate, and payback time. Let's walk through each one and see how it informs LEAP decisions.

Discounted Growth Model: The Foundation

The discounted growth model estimates what the business will earn over the next 10 years, discounts those earnings back to today's dollars, and compares that to the current stock price.

Formula simplified:

• Estimate annual earnings per share (EPS) for the next 10 years
• Apply a growth rate based on historical performance and industry trends
• Discount future earnings to present value using a required return (typically 10-15%)
• Add a terminal value (what the business is worth at year 10)
• Divide by shares outstanding to get intrinsic value per share

Example:

• Company: SteadyCo Inc.
• Current EPS: $6
• Expected growth: 8% per year (based on 10-year average)
• Required return: 12%
• Discounted value of 10 years of earnings: $85 per share
• Current stock price: $100

Conclusion: Stock is trading at a 15% premium to intrinsic value. Not a LEAP candidate. Skip it.

Example 2:

• Company: ValueCo Ltd.
• Current EPS: $8
• Expected growth: 10% per year
• Required return: 12%
• Discounted value: $140 per share
• Current stock price: $100

Conclusion: Stock is trading at a 29% discount to intrinsic value. Strong LEAP candidate.

The discounted growth model tells you how much the stock is undervalued. For LEAPs, you want at least 20% undervaluation to justify the leverage and time decay risk. Use the Wall St. Yardie App to simplify the process, it calculates discounted growth automatically.

Cap Rate Thinking: Real Estate Meets Stocks

The cap rate model treats stocks like rental properties. You compare the annual earnings yield (inverse of P/E ratio) to alternative investments and decide if the "rent" is worth the risk.

Formula:

• Earnings Yield = EPS ÷ Stock Price
• Cap Rate (for stocks) = Earnings Yield
• Compare to bond yields, savings rates, or real estate cap rates

Example:

• Stock price: $100
• EPS: $8
• Earnings yield: 8% ($8 ÷ $100)
• 10-year Treasury yield: 4%
• Real estate cap rate in your area: 6%

Conclusion: The stock "pays" 8% annually in earnings, double the safe rate (Treasuries) and better than real estate. If the business is stable and growing, this is a bargain.

Now apply this to LEAPs. Let's say you're considering a $90 strike LEAP priced at $15:

• Effective cost: $90 strike + $15 premium = $105 per share (your break-even)
• Earnings yield at break-even: $8 EPS ÷ $105 = 7.6%
• Still attractive: 7.6% beats Treasuries and most real estate

If the stock reaches intrinsic value ($140) within 18 months, your LEAP gains $35 per share ($140 stock - $105 effective cost). That's a 233% return on the $15 premium in 18 months. The cap rate model confirms the trade makes sense because the earnings yield supports the valuation even after accounting for the premium.

Payback Time: How Long to Recoup Your Investment

Payback time measures how many years of earnings it takes to "pay back" the stock price. It's the simplest valuation check and perfect for gut-checking LEAP decisions.

Formula:

• Payback Time = Stock Price ÷ EPS

Example:

• Stock price: $100
• EPS: $10
• Payback time: 10 years

If the company earns $10 per share every year, it takes 10 years of earnings to equal your $100 purchase price. For value investors, payback times under 10 years are attractive (assuming stable or growing earnings).

Now apply this to LEAPs:

• Stock price: $100
• Intrinsic value: $140
• Current payback time: 10 years ($100 ÷ $10 EPS)
• Intrinsic payback time: 14 years ($140 ÷ $10 EPS)

Wait, that looks worse. But here's the key: if earnings grow 8-10% per year, the payback time shrinks. By year 3, EPS might be $12.50, which means the stock at $140 has a payback time of 11 years, not 14. The growth is what justifies buying at $140.

For LEAPs, you're betting the market realizes this growth within 18-24 months. If payback time is already 15+ years at current prices, the stock is overvalued, and leverage amplifies the risk of overpaying.

Combining All Three Models for LEAP Decisions

Wall St Yardie uses all three models because each one catches different risks:

• Discounted growth catches stagnant businesses with no future growth
• Cap rate catches stocks where earnings yield is too low compared to safer alternatives
• Payback time catches stocks trading at nosebleed valuations even if growth is decent

Decision Framework:

If all three models say "Strong Buy," you have a legitimate case for using LEAPs. If one or two models are lukewarm, stick to stock ownership or wait for a better entry point.

Strike Price Selection Using Valuation Models

The models also guide strike price selection:

Conservative approach (high delta, low risk):

• Choose a strike 10-20% below current stock price (in-the-money)
• Higher premium, but behaves more like stock ownership
• Example: Stock at $100, strike at $85-90

Balanced approach (moderate delta, moderate risk):

• Choose a strike 5-10% below current stock price (slightly in-the-money)
• Moderate premium, balanced leverage
• Example: Stock at $100, strike at $90-95

Aggressive approach (low delta, high risk):

• Choose a strike at or above current stock price (at-the-money or out-of-the-money)
• Lower premium, maximum leverage, but higher risk of expiring worthless
• Example: Stock at $100, strike at $100-110

For value investors, the conservative or balanced approach makes the most sense. If intrinsic value is $140 and the stock is at $100, a $90 strike gives you $10 of intrinsic value immediately and only needs the stock to move $5 (to $105) to break even after time decay.

Example: Applying All Three Models

Let's walk through a complete valuation using all three models.

Company: UndervaluedCo Inc.

• Stock price: $80
• EPS: $8
• Expected growth: 10% per year
• Required return: 12%

Model 1: Discounted Growth

• Discounted value of 10 years of earnings: $120 per share
• Conclusion: 33% undervalued ($120 intrinsic value vs. $80 stock price)

Model 2: Cap Rate

• Earnings yield: $8 ÷ $80 = 10%
• Comparison: 10-year Treasury at 4%, real estate at 6%
• Conclusion: Earnings yield of 10% is highly attractive

Model 3: Payback Time

• Payback time: $80 ÷ $8 = 10 years
• With 10% growth, payback shrinks to 7-8 years by year 3
• Conclusion: Attractive payback time

LEAP Decision:

• All three models say "Strong Buy"
• Choose a $70 strike LEAP (in-the-money, high delta) for $15 premium
• Effective cost: $85 per share
• Upside if stock reaches intrinsic value ($120): $35 per share gain = 233% return on $15 premium
• Downside protection: $10 intrinsic value already baked in ($80 stock - $70 strike)

This is a textbook LEAP setup. All three models confirm undervaluation, the margin of safety is solid, and the risk-reward heavily favors the LEAP buyer.

What Could Go Wrong?

Even with solid valuation models, LEAPs can fail:

• Growth assumptions wrong: If you expect 10% growth but the company delivers 5%, intrinsic value drops and your LEAP loses value
• Market irrationality: The stock could stay at $80 for 2 years even though it's worth $120, time decay eats your premium
• Model inputs flawed: If you overestimate EPS or underestimate risk, the models produce bad valuations
• Ignoring catalysts: Valuation alone isn't enough, you need something to push the stock toward fair value (earnings beats, activist investors, industry tailwinds)
• Overpaying for premium: Even if intrinsic value is correct, paying $20 premium instead of $15 reduces your margin of safety

Mitigations: Use the Wall St. Yardie App to run multiple scenarios (base case, bull case, bear case), require all three models to agree before buying LEAPs, choose strikes with at least $5-10 intrinsic value already built in, and always keep 10-20% cash as dry powder for better opportunities.

Next Steps

• Calculate intrinsic value on 3 stocks: Pick stocks you're considering and run all three models (use Wall St. Yardie to simplify the process)
• Compare models: See if all three agree or if one model flags a risk the others miss
• Paper trade: If all three models say "Strong Buy," simulate buying a LEAP on paper and track performance for 6 months
• Refine inputs: As earnings reports come out, update your EPS and growth assumptions, see if the valuation thesis still holds
• Read more: Check out Position Sizing with LEAPs to learn how to allocate capital across multiple LEAP positions, and Maintaining Margin of Safety with LEAPs to preserve downside protection even with leverage