The writer is Professor Emeritus at the Kellogg School of Management and co-author of the recently updated Expectations Investing.
A stock price contains a wealth of information about the market’s expectations for a company’s future performance. Investors who correctly read market expectations and anticipate revisions increase their chances of obtaining above-average returns.
Many investors think they incorporate expectations into their decisions, but few do so rigorously and explicitly.
Sometimes it’s good to get back to basics. Investors looking for returns above the market should find stocks with significant differences in price and value. The problem is, the price is known but not the value.
In an efficient market, where stocks reflect all available information about a company’s outlook, price equals value. Economists who conduct laboratory experiments can point to value and then test the relationship between price and value. Their work reveals that price and value can come together very quickly even in cases where each investor has only partial information.
But studies also show that price and value can diverge significantly when investors converge on valuations that are too bullish or bearish, leading to outbursts of extreme optimism or pessimism. Opportunities for excess returns exist.
The value is equal to the present value of a company’s future cash flows. Few investors disagree with this in theory, but many are wary of analytical models that value, or “discount”, future cash flows because they find them too speculative.
As a result, most market practitioners use a shorthand for the valuation process such as multiples of the price to earnings. You often see analysts estimate value by applying a multiple to projected earnings and relating it to price.
Investors also like to compare the multiples of companies with those of their peers when looking for the most promising investments. Indeed, psychological research shows that people are good at discerning the relative attractiveness of stocks. The problem is that the price may differ from the value for all stocks compared.
And while multiples save time, they also lack clarity as they confuse key drivers of business value such as sales growth, profit margins, and investment needs.
Another way to identify an opportunity is to ask what an investor needs to believe about a company’s future cash flow to justify the share price. My co-author, Michael Mauboussin, and I call this the investment of expectations.
John Maynard Keynes, the economist, recognized the importance of this approach when he wrote: “The actual results of an investment over long years very rarely match initial expectations. Investing in expectations addresses concerns about long-term cash flow forecasts in discounted cash flow models, views the world probabilistically, and overcomes the shortcomings of traditional analysis that uses multiples.
The process has three stages. The first is to read the implicit price expectations. This changes the traditional application of a DCF model by starting with price and then discerning market expectations for a company’s value drivers. This step is most effective when the investor remains open-minded about the price.
The second step applies strategic and financial analysis to assess whether expectations are too optimistic, pessimistic, or about right. Strategic analysis includes understanding the landscape in which the company operates, assessing the attractiveness of the industry and identifying sources of competitive advantage specific to the company.
Financial analysis requires determining which value factor is most important and developing a thoughtful scenario analysis to capture a range of potential outcomes and the likelihood that they will occur. These scenarios produce the expected value of the stock, the sum of each outcome multiplied by the probability of its occurrence.
The last step is to compare the expected value with the stock price and make a buy or sell decision. A sufficiently large difference between the price and the expected value is necessary to ensure a safety margin.
Aswath Damodaran, a leading valuation authority, calls investment expectations “so powerful and yet so obvious” that “your tendency is to bang your head and wonder why you haven’t thought about it. To [it] first. ”The approach harnesses the power of a DCF model without the pitfalls, and provides a disciplined means of making investment decisions.
Michael Mauboussin, researcher at Morgan Stanley Investment Management and co-author of Expectations Investing, contributed to this article.