Valuing stocks: why investors should look harder at expectations

The writer is professor emeritus at Kellogg School of Management and co-author of recently-updated Expectations Investing

A stock price contains a treasure trove of information about the market’s expectations of a company’s future performance. Investors who properly read market expectations and anticipate revisions increase their odds of achieving above-average returns.

Many investors believe they are incorporating expectations in their decisions, but few do so rigorously and explicitly.

Sometimes it is good to go back to basics. Investors who seek market-beating returns need to find stocks with meaningful differences between their price and value. The problem is that price is known but value is not.

In an efficient market, where stocks reflect all available information about a company’s prospects, price equals value. Economists who run experiments in laboratories can designate 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 the studies also show that price and value can diverge meaningfully when investors converge on overly bullish or bearish assessments, leading to bouts of extreme optimism or pessimism. Opportunities for excess returns exist.  

Value equals 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 price to earnings. You often see analysts estimate value by applying a multiple to projected earnings and relating it to the price.

Investors also like to compare the multiples of companies with those of peers when seeking the most promising investments. Indeed, psychological research shows that people are good at discerning relative attractiveness of stocks. The problem is that price may differ from value for all the stocks being compared.

And while multiples save time, they also lack clarity because they conflate the key drivers of corporate value such as sales growth, profit margins and investment needs.

Another way to identify opportunity is to ask what an investor needs to believe about a company’s future cash flows to justify the stock price. My co-author, Michael Mauboussin, and I call this expectations investing.

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.

Michael Mauboussin, researcher at Morgan Stanley Investment Management and co-author of Expectations Investing, contributed to this article.

​Letter in response to this article:

Portfolio managers need to follow herd to survive / From Daniel Mauro, Chief Investment Officer, Army Capital, Chicago, IL, US