The author is Professor Emeritus at the Kellogg School of Management and co-author of the recently updated Expectations Investing
A stock price contains a treasury with information about the market’s expectations of a company’s future performance. Investors who read the market expectations properly and expect revisions increase their chances of achieving above-average returns.
Many investors believe that they incorporate expectations into their decisions, but few do so strictly and explicitly.
Sometimes it’s good to get back to basics. Investors looking for market returns need to find stocks with significant differences between their price and value. The problem is that the price is known, but the value is not.
In an efficient market, where stocks reflect all available information about a company’s prospects, price equals value. Economists conducting experiments in laboratories can indicate value and then test the relationship between price and value. Their work shows that price and value can come together very quickly, even in cases where each investor has only partial information.
But the studies also show that price and value can deviate significantly when investors converge on an overly strong or clumsy rating, which can lead to extreme optimism or pessimism. Opportunities for excess returns exist.
Value equals the present value of a business’s future cash flow. Few investors differ from 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 multiple from price to earnings. You often see that analysts estimate the value by applying a multiple to the expected earnings and relating it to the price.
Investors also like to compare the multiplicity of businesses with that of peers when looking for the most promising investments. Psychological research indeed shows that people are good at distinguishing between the relative attractiveness of stocks. The problem is that the price may differ from the value for all the shares being compared.
Although it saves multiple times, it also lacks clarity because it combines the key drivers of corporate value, such as sales growth, profit margins and investment needs.
Another way to identify the opportunity is to ask what an investor should believe about the future cash flow of a business to justify the share price. My co-author, Michael Mauboussin, and I call it investing.
Economist John Maynard Keynes acknowledged the importance of this approach when he wrote: “The actual results of a long-term investment very rarely match the initial expectation.” Investing expectations address concerns about predicting long-term cash flow in cash flow discount models, view the world likely, and overcome the shortcomings of traditional analysis using multiples.
The process has three steps. The first is to read price-implied expectations. It gives a twist to the traditional application of a DCF model by starting with the price and then distinguishing the market’s expectations for the value managers of a business. This step is most effective if the investor stays open about the price.
The second step applies strategic and financial analysis to determine if expectations are too optimistic, pessimistic, or right. Strategic analysis involves understanding the landscape in which the business operates, the attractiveness of the industry and identifying firm-specific sources of competitive advantage.
Financial analysis requires determining which valuator is the most important and developing a thoughtful scenario analysis to determine a range of possible outcomes and the probabilities that this will happen. These scenarios yield the expected value of the stock, multiplying the sum of each outcome by the probability that it will happen.
The last step is to compare the expected value with the share price and make a decision to buy or sell. A sufficiently large difference between price and expected value is necessary to ensure a safety margin.
Aswath Damodaran, a leading authority in the field of valuation, calls investment investing ‘so powerful and yet so obvious’ that’ your tendency is to shake your head and ask yourself why you did not think about it [it] first ”. The approach leverages the power of a DCF model without the pitfalls, and provides a disciplined way to make investment decisions.
Michael Mauboussin, researcher at Morgan Stanley Investment Management and co-author of Expectations Investing, contributed to this article.