The eBay reward

eBay is cheap; too cheap.

An important concept in investing is the risk reward ratio. Normally to have the chance of gaining more you have to risk more. If you want the chance to make £1 million from £1 then you need to play the lottery, with every chance that you will lose all you £1. If you are happy to make a risk-free 5% on your capital every year then a saving account is for you. Most other forms of investment lie in between these extremes.

Sometimes a situation crops up where the risk reward ratio is in the investors favour. This might be a situation where the worst case scenario is break even after 12 months and the best case is 50% gain. This is the case with eBay at $43.45.

eBay's trailing PE is currently 56. This is cheap by eBay standards; in the dark days of May last year is dropped to 50. In the bubble days of late 2004 it was well above 100.

eBay is forecast to earn about $1 per share in 2006. So lets look at three scenarios.

1) Everything goes as forecast. EPS of $1. Trailing PE of 55(as now.) Share price = $55. Growth = 26%

2) Everything goes fantastically well. EPS of $1.10. Trailing PE of 65. Share price = 71.5. Growth = 64%

3) Everything disappoints. EPS of $0.90. Trailing PE of 45. Share price = 40.5. Growth = -7%.

So the worst is a small loss and the best is 64% growth. I will take those sort of odds! eBay is uniquely low risk because of its lack of direct competition and the power of its user community. eBay is becoming part of the language. Buying on eBay is fun. Analysts don't talk about that point but it is important. Buying on classified listing sites is not fun - at present anyway. There is no community.

The upshot of all this is that today I will be betting my mortgage on eBay. Well not quite but almost. I will be selling Microsoft for a small gain (about 5% probably - should have sold at $28!) I will be plowing the proceeds into eBay. I am tired of my mortgage portfolio containing slow-growing blue chips. They are supposed to be low risk but Vodafone is down over 20% from its highs of last summer. Dividends are nice but 30% earnings growth is better.

I still think some level of diversification is important so I will not put all my mortgage portfolio into eBay, only 25% of it. After all I may be wrong in my judgment. Do your own research.