Valuing stocks: why investors should look harder at expectations
Valuing stocks is often a tricky exercise which is why most market participants take the easy route of using multiples, the shortcomings of which we have discussed at length in our newsletters – here and here. Whilst in theory, the value of a company is the present value of its future cashflows, in practice it is less of an exact science as the estimation of future cashflows relies on several subjective qualitative judgements the analyst has to make. The quality of such judgements in turn is a factor of the depth of research and understanding of the company’s fundamentals. In this piece, Alfred Rappaport, the co-author of the book Expectations Investing along with Michael Mauboussin, helps us with another way of making sense of value. Rather than making explicit forecasts of cashflows, we work backwards to estimate what cashflow profile when discounted equates the current stock price and then using strategic and financial analysis, assess if that cashflow profile understates or overstates the strength and sustainability of fundamentals.
“John Maynard Keynes, the economist, recognised the importance of this approach when he wrote: “The actual results of an investment over a long term of years very seldom agree with the initial expectation.” Expectations investing addresses concerns about the forecast of long-term cash flows in discounted cash flow models, views the world probabilistically and overcomes the shortcomings of traditional analysis that uses multiples.
The process has three steps. The first is to read price-implied expectations. This puts a twist on the traditional application of a DCF model by starting with price and then discerning the market’s expectations for a company’s value drivers. This step is most effective when the investor remains open-minded about what is priced in.
The second step applies strategic and financial analysis to assess whether the expectations are too optimistic, pessimistic or about right. Strategic analysis includes understanding the landscape within which the company operates, assessing the attractiveness of the industry, and identifying firm-specific sources of competitive advantage. Financial analysis requires determining which driver of value is most important and developing thoughtful scenario analysis to capture a range of potential outcomes and the probabilities that they will happen. These scenarios produce the stock’s expected value, the sum of each outcome multiplied by the probability of its occurrence.
The final step is to compare the expected value with the stock price and to make a decision to buy or sell. A sufficiently large difference between price and expected value is necessary to ensure a margin of safety.
Aswath Damodaran, a leading authority on valuation, calls expectations investing “so powerful and yet so obvious” that “your inclination is to whack your head and ask yourself why you did not think of [it] first”. The approach harnesses the power of a DCF model without the pitfalls, and provides a disciplined way to make investment decisions.”