The 3 steps of Expectations Investing by Michael Mauboussin

TL;DR

Expectations investing involves reverse engineering stock prices, conducting historical and strategic analysis, and making buy, sell, or hold decisions based on valuation models.

Transcript

expectations investing has three steps the first step is to go backwards and say the only thing we know for sure in this whole equation is the price so let's go back and reverse engineer using a discounted cash flow model which is an appropriate way to think about economic both theoretically and i think practically think about what has to happen fo... Read More

Key Insights

• ☠️ Expectations investing involves reverse engineering stock prices to understand the drivers of value, such as sales growth rate, margins, and capital intensity.
• ⚾ Historical and strategic analysis helps determine whether a company will meet or exceed expectations, and the valuation should be based on the company's expected performance.
• ❓ Multiples should not be mistaken for valuation; they are shorthand representations of the valuation process and require understanding of the economic implications.
• 🔠 Growth should be qualified based on the return on capital and cost of capital spread to determine if it adds value or not.
• 💐 Explicit valuation models, like discounted cash flow models, provide a clear understanding of future value creation and investment needs.
• 🥺 Using multiples without understanding the underlying economic assumptions can lead to misleading valuations and investment decisions.
• 🤔 Expectations investing emphasizes probabilistic thinking, considering different scenarios and assigning probabilities to potential outcomes.

Questions & Answers

Q: What are the three steps of expectations investing?

The three steps include reverse engineering stock prices using a discounted cash flow model, analyzing historical and strategic factors, and making decisions based on the valuation model.

Q: How should one use valuation multiples in expectations investing?

Valuation multiples, such as PE and EV/EBITDA, should be used as shorthands for the valuation process, but one must understand the economic assumptions underlying those multiples for them to make sense.

Q: What is the importance of historical and strategic analysis in expectations investing?

Historical and strategic analysis helps assess whether a company will meet, exceed, or fall short of expectations by evaluating its past performance and future strategies.

Q: Why is growth not always value-creating in expectations investing?

Growth only adds value when a company earns above the cost of capital. Therefore, it is important to consider the return on capital and cost of capital spread before qualifying growth as value-creating.

Summary & Key Takeaways

• Expectations investing consists of three steps: reverse engineering stock prices using a discounted cash flow model, analyzing historical and strategic factors to evaluate a company's performance, and making decisions based on the valuation model.

• Multiples, such as PE and EV/EBITDA, should not be confused with valuation, but considered as shorthands for the valuation process, relying on economic assumptions.

• Growth alone does not guarantee value creation; growth only adds value when a company earns above the cost of capital.