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Excerpts from the Book > Chapter 2

Chapter 2 : How the Market Values Stocks

Excerpt from Chapter 2

With traditional discounted cash flow analysis, you forecast cash flows to estimate a stock's value. Expectations investing reverses the process. It starts with a rich, underutilized source of information—the stock price—and determines the cash flow expectations that justify that price. Those expectations, in turn, serve as the benchmark for buy, sell, or hold decisions.

Questions Addressed in Chapter 2

To understand how the market values stocks, Chapter 2 answers the following questions:

  • Do prices in financial markets really reflect expected future cash flows?
  • Unlike bonds, stocks do not have contractually specified cash flows and a date when principal is repaid. Given this, exactly what future cash flows do stock prices actually reflect?
  • How do the three primary Operating Value Drivers—namely, Sales Growth Rate (%), Operating Profit Margin (%), and Incremental Investment Rate (%)—affect shareholder value?
  • How do the three Other Value Determinants—namely, the Cash Tax Rate (%), Cost of Capital (%), and Forecast Period (years)—affect shareholder value?
  • How do the value drivers and determinants fit together to create the Shareholder Value Roadmap?

Essential Ideas in Chapter 2

  • The magnitude, timing, and riskiness of cash flows determine the market prices of financial assets, including bonds, real estate, and stocks.
  • You can estimate the value of a stock—its shareholder value—by forecasting free cash flows and discounting them back to the present.
  • Rather than struggle to forecast long-term cash flows or employ unreliable short-term valuation proxies, expectations investors establish the future cash flow performance implied by stock prices as a benchmark for deciding whether to buy, hold, or sell.

 

Chapter Errata

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List of Errata in this Chapter

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