Circuit City: Electric returns aren't a safe bet

Q: What will be the future of Circuit City CC?

A: Circuit City has been short-circuiting the portfolios of investors who bet this company could turn itself around.

The seller of consumer electronics is in a tough position. The slow economy hurts sales of pricey products such as the large-screen TVs, digital music players and digital cameras that Circuit City sells. Many consumers, fearful of falling home values or worried about losing their jobs, can stick with their existing digital gizmos rather than spend the money to upgrade.

The next big problem for Circuit City is the incredible competition. Best Buy bby continues to be the bricks-and-mortar electronics retailer to beat. While Circuit City has laid off employees, Best Buy has improved its customer service. You can read more in this story from earlier this summer.

Meanwhile, Circuit City is going toe-to-toe with some of the best online retailers around. Amazon.com amzn offers a large array of consumer electronics, including big-screen TVs. And there are some excellent specialty retail sites, such as newegg.com and crutchfield.com.

So, Circuit City has its work cut out for it. Shares are down 58% this year and are trading for less than $2. Is the stock worth taking a chance on at that price? To find out, let's put it through the four tests we consider at Ask Matt:

Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Circuit City's trading history back to 1984, we see the company generated an average annual compound rate of return of 103%. That is a healthy return, handily beating the S&P 500.

But to beat the S&P 500, you accepted risk — standard deviation — of 65 percentage points. That's 342% greater than S&P 500's risk during the period. So to get an 816% higher return you accepted 342% higher risk. As long as you can tolerate a stock that generates tremendous volatility, Circuit City stock passes this test.

Step 2: Measure the stock's discounted cash flow. Some investors decide if a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs. When we run Circuit City's stock, we find it's rated "dangerous." In other words, the current stock price is much greater than what the company is expected to generate in cash over its lifetime. Using this analysis, it would appear Circuit City isn't a bargain.

Step 3: Compare the stock's current valuation to its historical range. BetterInvesting's Stock Selection Guide can help. If the company can increase earnings 12% a year the next five years that would put the stock in the "sell" range. That's a flashing red light for investors who believe the price-to-earnings ratio will return to historical norms. Keep in mind, though, the company lost money in 2007, according to BetterInvesting data, so the analysis is based on just four years of earnings: 2003, 2004, 2005 and 2006.

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