March's Stock Red Flags

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This article originally appeared in Morningstar StockInvestor.

In tables, click Star Rating, Business Risk, and Size of Moat to see definitions of these terms. Definitions are hosted on Morningstar.com.

We calculate the Risk-Adj. Ret by taking a stock's fair value and assume it will grow at the company's cost of equity over the next five years. This is the stock's fair value in five years. We then subtract out the "risk" of the stock--defined as its cost of equity plus a margin of safety. All data below are as of Feb. 28, 2006.

Despite having yet to generate a profit, XM Radio XMSR and Sirius Satellite Radio SIRI have been two of the most popular and actively traded stocks on Wall Street the past couple of years. While we agree that XM and Sirius have several robust years of subscriber growth ahead of them, we think the stock market has always overvalued the firms' future cash flow generating capabilities.

We were a month early when we profiled Sirius in this space back in November 2004: the stock rose from $3.90 at the end of October that year to $9.43 in December before recently declining to about $5 per share. However, since XM's inclusion as a Red Flag in June, the firm's shares have fallen about 33%.

In August, analyst Michael Corty raised his fair value estimates for XM from $7 to $20 per share and Sirius' from $0.50 to $2 to reflect a more-optimistic industry outlook. Although subscription growth at both companies is strong thanks to attractive content and relationships with auto manufacturers, Sirius incurred an $860 million operating loss in 2005, while XM lost $540 million.