An example of a faulty structure is a near-messianic focus on shortterm earnings. As it turns out, short-term earnings are not very helpful for gauging expectations because they are a poor proxy for how the market values stocks. (Location 217)
Seen in this light, stock prices are gifts of information—expectations—waiting for you to unwrap and use. If you’ve got a fix on current expectations, then you can figure out where they are likely to go. Like the great hockey player Wayne Gretzky, you can learn to “skate to where the puck is going to be, not where it is.”1 That’s expectations investing. (Location 223)
expectations investing is a stock-selection process that uses the market’s own pricing model, the discounted cash-flow model, with an important twist: Rather than forecast cash flows, expectations investing starts by reading the expectations implied by a company’s stock price. (Location 227)
We believe that expectations investing can translate this heightened uncertainty into opportunity. (Location 251)
Most investors use accounting-based tools, like short-term earnings and price-earnings multiples. (Location 272)
even less useful as companies increasingly depend on intangible rather than tangible assets to create value. We expand on the shortcomings of earnings as poor proxies for market expectations in the last section of this chapter. (Location 273)
The only investors who earn superior returns are those who correctly anticipate changes in a company’s competitive position (and the resulting cash flows) that the current stock price does not reflect. (Location 360)
Studies confirm that you must extend expected cash flows over many years to justify stock prices. Investors make short-term bets on long-term outcomes. (Location 366)
In a discounted cash-flow model, value increases only when the company earns a rate of return on new investments that exceeds the cost of capital. (Location 387)
Consequently, higher earnings do not always translate into higher value. (Location 389)
Cash flow was about 80 percent of earnings for the group, and earnings exceeded cash flow for twenty-three of the thirty companies.13 (Location 395)
expectations game has two unintended consequences. First, it induces security analysts to fixate on quarterly earnings estimates at the expense of independent analysis. (Location 424)
present sales level and margins for the foreseeable future. With a 12 percent cost of equity capital, EGI’s shareholder value is $9 million divided by 12 percent, or $75 million. (Location 457)
A dollar today is worth more than a dollar in the future, because you can invest today’s dollar and earn a positive rate of return, a process called compounding. (Location 496)
Given that the magnitude, timing, and riskiness of cash flows determine the value of bonds and real estate, we can expect these variables to dictate stock prices as well, even though the inputs for stocks are much less certain. (Location 508)
stocks with discounted cash flow? Certainly not. After all, the returns that investors receive when they purchase any financial asset depend on the cash flows that they pocket while owning the asset plus their proceeds when selling (Location 512)
First, market prices respond to changes in a company’s cash-flow prospects. Second, market prices reflect long-term cash-flow prospects. As noted in chapter 1, companies often need ten years of value-creating cash flows to justify their stock price. For companies with formidable competitive advantages, this period can last as long as thirty years. (Location 518)
operating value drivers—sales growth, operating profit margin, and investment (Location 541)
value determinant, cash tax rate, determine free cash flow. (Location 542)
Let’s begin with fixed capital investment. For insights into market expectations, we should use a publicly available service that provides long-term forecasts, such as Value Line Investment Survey and analyst projections, to estimate a company’s incremental fixed-capital investment rate, (Location 588)
we calculate the rate by dividing capital expenditures, minus depreciation expense, by the change in sales forecasted for the same period. (Location 591)
The answer depends on the relative stability of a company’s product mix, on technological changes, and on the company’s ability to offset increased fixed-capital costs through higher selling prices or using fixed assets more efficiently. (Location 595)
incremental working-capital investment rate. (Location 598)
Operating working capital equals current assets (accounts receivable and inventory) minus non-interest-bearing current liabilities (accounts payable and accrued liabilities). (Location 599)
Changes in working capital underscore the difference between earnings and cash flow. (Location 601)
Inventories also generally rise as sales increase. Rising inventory requires cash payments for materials, labor, and overhead. Since cost of goods sold excludes the cash outlays for additional inventory, we must include it as a working-capital investment. (Location 604)
Residual value, the value of post-forecast free cash flows, often constitutes most of a company’s total value. (Location 614)
We recommend either the perpetuity method or the perpetuity-with-inflation method, although perpetuity with inflation works better for most companies. (Location 615)
No single residual value formula is appropriate in all circumstances; your assumptions about the business’s competitive position at the end of the forecast period will determine which method you choose.6 (Location 622)
The cost of capital incorporates the expected returns of both debtholders and shareholders since both groups have claims on free cash flow. (Location 680)
and an additional return for investing in more risky stocks, or an equity risk premium.8 (Location 696)
Investors should base the market risk premium on expected rates of return, not on historical rates, because the increased volatility of interest rates since the early 1980s has raised the relative risk of bonds and lowered the market risk premium. (Location 746)
texts that advocate arbitrary five- or ten-year periods. (Location 807)
The forecast period is the time that the market expects a company to generate returns on incremental investment that exceed its cost of capital. According to market-validated economic theory, companies that generate excess returns attract competition that eventually drives industry returns toward the cost of capital. (Location 808)
Assume that last year’s sales were $100 million and that you expect the following value drivers to be constant over an entire five-year forecast period: (Location 839)
we need one more set of analytical tools: the value factors (Location 916)
We now know where to begin to look for revisions in expectations: the value triggers. (Location 918)
That depends on whether a company is creating shareholder value, that is, whether a company generates returns on its growth investments that exceed its cost of capital. (Location 1025)
growth adds no value. (Location 1027)
Obviously, the higher the margin, the better. However, just to maintain its value, a company needs to earn a certain break-even operating profit margin, which we call the threshold margin (Location 1031)
Its relative importance is largely a function of the availability of historical data and industry stability (Location 1122)
The long-term discounted cash-flow model best captures the stock market’s pricing mechanism. (Location 1375)
think forecasting distant cash flows is extraordinarily hazardous. (Location 1376)
As Warren Buffett says, “Forecasts usually tell us more of the forecaster than of the future.”1 Where, then, do you turn? (Location 1377)
Think about it this way: It’s hard for an individual to forecast an uncertain future better than the collective wisdom of the market can. So why not get the “answer” about the PIE directly from the source? (Location 1383)
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You just need to know how to read the market today—and anticipate what the expectations are likely to be tomorrow. (Location 1388)
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Investors who assume that the market focuses on the short term are amazed to find that it actually takes a long-term view. (Location 1391)
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In chapter 2, we showed that a combination of free cash flows, the cost of capital, and a forecast period determines value in a discounted cash flow model. (Location 1397)
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It starts with stock price (as distinct from value) and then estimates the expectations for cash flow, the cost of capital, and the forecast horizon. (Location 1399)
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In fact, you will find it very difficult to capture market expectations accurately, especially for young, knowledge-oriented companies, without incorporating past and future ESO grants. (Location 1428)
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The final value determinant is the number of years of free cash flows required to justify the stock price. We call this horizon the marketimplied forecast period (it’s also called “value growth duration” and “competitive advantage period”).4 (Location 1434)
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The sales growth rate, operating profit margin, and cash tax rate determine net operating profit after tax (NOPAT). (Location 1453)
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At the time of the analysis, the yield on the risk-free ten-year treasury bond was 5.85 percent, the market risk premium estimate was 3.2 percent, and beta was 1.30, according to Value Line. (Location 1458)
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Four building blocks—two data sets and two tools—serve as the foundation for identifying expectations opportunities (figure 6-2). (Location 1603)
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owing solely to cost efficiencies—to create a comparable impact on shareholder value. Look at the result, and consider the likelihood that the margin will be that variable. (Location 1648)
PIE operating profit margin is 10 percent and that it would have to range from a high of 17 percent to a low of 3 percent to generate the same shareholder-value impact as the high and low estimates of sales growth rate. (Location 1650)
Specifically, drill down one more level to the leading indicators of value (Location 1658)
Researchers find that people consistently overrate their abilities, knowledge, and skill, especially in areas outside their expertise. (Location 1675)
Remember the overconfidence trap when you estimate the high and low scenarios for sales growth as part of the initial step in the three-step search for expectations opportunities. (Location 1678)
Try not to overestimate your abilities—know thyself. • Allow for a margin of safety. • Challenge your high and low estimates. • Seek feedback from others. (Location 1685)
What are the leading indicators for Gateway’s sales growth? First, we need to assess the contributors to sales growth embedded in PIE. Table 6-4 shows a breakdown of Gateway’s base year sales and the anticipated growth rate for the three major segments. (Location 1911)
However, the prospect of an excess return is by itself not enough to signal a genuine buying opportunity. You still must decide whether the excess return is sufficient to warrant purchase. (Location 2153)