Case Study: Finding a Stock for LEAPs

A stock trading at $80 might look expensive until you realize it's worth $140. The gap between price and value is where LEAPs shine. But finding that gap requires more than hope. It demands a systematic approach to identifying undervalued companies with genuine long-term growth potential.

TL;DR

• Start with quality: Only consider LEAPs on companies with strong competitive advantages, consistent earnings growth, and healthy balance sheets
• Calculate intrinsic value first: Use discounted growth or cap rate models to determine what the business is actually worth
• Demand a margin of safety: Buy LEAPs only when the stock trades at least 25-30% below your calculated value
• Verify growth durability: Ensure the company can reinvest earnings at high rates for the next 5-10 years
• Use Wall St Yardie to quickly screen for undervalued growth candidates

Why LEAPs Require Better Stock Selection

LEAPs are long-dated options expiring 1-3 years in the future. Unlike short-term options, they give companies time to prove their worth. But that time cuts both ways. A poor stock choice that declines slowly will erode your entire investment as theta decay chips away at the premium.

That's why stock selection matters more for LEAPs than almost any other options strategy. You're making a multi-year bet that the company will grow earnings, that the market will eventually recognize that growth, and that both will happen before expiration.

The good news? Value investing principles already solve this problem. Find wonderful companies trading below intrinsic value, and you stack the odds in your favor.

Step 1: Identify Quality Companies First

Before looking at price, filter for quality. LEAPs work best on companies that can grow earnings consistently for years. That requires competitive advantages, what Warren Buffett calls "economic moats."

Look for:

• High return on invested capital (ROIC): Companies earning 15%+ on the money they reinvest tend to compound well over time
• Recurring revenue or strong customer loyalty: Subscription businesses, brand-driven companies, and mission-critical services tend to grow more predictably
• Low debt relative to earnings: Heavy debt creates refinancing risk that can derail even good businesses
• Management with skin in the game: Insider ownership aligns incentives with shareholders

For this case study, let's examine a hypothetical company called GrowthTech, a software business serving enterprise customers.

GrowthTech Profile:

• Current price: $75 per share
• Earnings per share: $4
• 5-year average earnings growth: 14%
• Return on invested capital: 22%
• Debt-to-equity ratio: 0.3
• Recurring revenue: 85% of total sales

This profile suggests durability. High ROIC means the business generates strong returns on reinvested earnings. Low debt reduces financial risk. Recurring revenue provides visibility into future cash flows.

Step 2: Calculate Intrinsic Value

Now determine what GrowthTech is actually worth. We'll use a multi-year discounted cash flow approach since this is a growth company.

Approach: Project future earnings, discount them to present value, then sum them up.

Inputs:

• Current earnings: $4 per share
• Projected growth rate: 12% (conservative, below historical 14%)
• Discount rate: 10% (required return for a stable growth company)
• Terminal growth rate: 3% (long-term sustainable rate after year 10)

Calculation: For the next 10 years at 12% growth: Year 1: $4 × 1.12 = $4.48 Year 5: $4 × (1.12)^5 = $7.05 Year 10: $4 × (1.12)^10 = $12.43

Present value of Year 10 earnings at 10% discount rate: $12.43 / (1.10)^10 = $4.79

This simplified snapshot understates true value because it ignores interim earnings. A full discounted cash flow model would sum all years. For quick screening, Wall St Yardie handles these calculations automatically.

Using a more complete model, GrowthTech's intrinsic value comes out around $105 per share.

Margin of Safety: GrowthTech trades at $75. Intrinsic value is $105. That's a 29% discount, providing a solid margin of safety.

Step 3: Verify Growth Durability

Valuation models assume growth continues. But will it? This step separates speculative hopes from reasonable expectations.

Ask these questions:

Is the addressable market still expanding? GrowthTech serves enterprise software needs. The market for cloud-based business tools continues growing as more companies digitize operations. Check.

Can the company reinvest earnings profitably? With 22% ROIC, GrowthTech turns every dollar of retained earnings into $0.22 of additional profit. As long as management finds productive uses for cash, growth can compound. Check.

Are competitive advantages strengthening or weakening? GrowthTech's switching costs (customers built workflows around the software) create stickiness. New features and integrations deepen this moat over time. Check.

What could disrupt growth? Technology shifts, new competitors, or economic downturns could slow sales. GrowthTech's diversified customer base and subscription model reduce these risks, but they don't eliminate them.

For LEAPs, you want high confidence that growth persists for at least 2-3 years, the typical LEAP time horizon.

Step 4: Select the Right LEAP Contract

Now that GrowthTech passes quality and valuation tests, choose the LEAP itself.

Expiration selection: For value investors, 18-24 month expirations work best. This gives the stock time to revalue toward intrinsic worth while minimizing time decay costs. GrowthTech has January 2027 LEAPs available, giving us 24 months.

Strike selection: Deep in-the-money (ITM) LEAPs cost more but have higher delta (more stock-like behavior) and less time value decay. At-the-money (ATM) LEAPs balance leverage with risk.

GrowthTech trades at $75. A $60 strike LEAP (deep ITM) might cost $20, providing $15 of intrinsic value plus $5 of time value. This contract moves nearly dollar-for-dollar with the stock.

A $75 strike LEAP (ATM) might cost $12, all time value. More leverage if the stock rises significantly, but total loss if the stock stays flat.

For a value approach, prefer ITM strikes. You're betting on the gap between price and value closing, not on explosive upside. ITM LEAPs behave more like owning shares at lower capital cost.

Position sizing: Never allocate more than you can afford to lose. LEAPs can go to zero if the stock declines enough or if your thesis is wrong. A reasonable allocation might be 3-5% of your portfolio per LEAP position.

Real Numbers: The Potential Outcome

Scenario: GrowthTech rises from $75 to $95 over 18 months (still below $105 intrinsic value)

Stock ownership: Buy 100 shares at $75 = $7,500 invested. Gain: $2,000 (27% return).

LEAP ownership: Buy 3 contracts at $60 strike for $20 each = $6,000 invested (controls 300 shares). At $95, each contract is worth $35. Total value: $10,500. Gain: $4,500 (75% return).

LEAPs amplify the same underlying move. But remember: if GrowthTech drops to $55, the stock investor loses 27% while the LEAP investor could lose nearly everything (the LEAPs might be worth only $3-5 each).

This asymmetry is why stock selection matters so much. You need conviction that the stock is genuinely undervalued.

What Could Go Wrong?

Growth slows unexpectedly: If GrowthTech's growth drops from 12% to 5%, intrinsic value falls significantly. Your LEAPs lose value even if the stock doesn't crash. Mitigation: Use conservative growth estimates. If historical growth is 14%, model 10-12%.

Market stays irrational: Sometimes undervalued stocks stay undervalued for years. Your LEAPs could expire before the market recognizes the company's worth. Mitigation: Choose longer expirations (2+ years) and be prepared to roll if necessary.

Sector rotation hurts the stock: Even wonderful companies get sold during market panics or sector rotations. Mitigation: Size positions appropriately and maintain diversification across your overall portfolio.

Time decay accelerates: In the final 6 months before expiration, theta decay speeds up. Mitigation: Roll or close positions before the final acceleration period.

Your valuation is wrong: Maybe intrinsic value isn't $105 but $80. Mitigation: Demand a significant margin of safety (25-30% or more) to protect against errors.

Next Steps

• Screen for candidates: Use Wall St Yardie to identify stocks trading significantly below calculated intrinsic value with consistent earnings growth
• Run quality filters: Check ROIC, debt levels, and moat strength before any valuation work
• Calculate intrinsic value: Apply discounted growth models to growth companies, cap rate thinking to mature businesses
• Verify growth durability: Ask whether the company can sustain high returns for 2-3+ years
• Select the right contract: Prefer deep ITM strikes and 18-24 month expirations for value-oriented LEAPs
• Size conservatively: Allocate 3-5% maximum per LEAP position
• Review related concepts: Read Why Stock Selection Matters in Options and Intrinsic Value as a Starting Point

Finding the right stock for LEAPs isn't about chasing the hottest trend. It's about methodically identifying quality companies trading below their worth, then using long-dated options to amplify that value gap. Do the work upfront, demand a margin of safety, and let time work for you. That's how disciplined investors use LEAPs to build wealth without reckless speculation.