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Excerpts from the Book > Chapter 3

Chapter 3 : The Expectations Infrastructure

Excerpt from Chapter 3

Expectations investing rests on two simple ideas: (1) you can read stock prices and estimate the expectations that they imply. (2) you will earn superior returns only if you correctly anticipate revisions in those price-implied expectations.

The market values stocks using the discounted cash flow model, and so we'll use it to read expectations. The familiar operating value drivers—sales growth, operating profit margin, and investment—express price-implied expectations. But now we turn our attention to expectations revisions. In this chapter, we deal with two fundamental questions:

  1. Where should we look for expectations revisions?
  2. Are all expectations revisions created equally?

The answers are vital because they hold the key to earning superior investment returns. Knowing today's expectations is one thing, but knowing what they'll be and the impact they'll have on shareholder value is another thing altogether.

Questions Addressed in Chapter 3

To develop the concept of "expectations infrastructure," Chapter 3 answers the following questions:

  • Sales, operating costs, and investments function as value triggers, the fundamental building blocks of shareholder value. However, these value triggers are too broad to map directly on the operating value drivers we described in chapter two. How can we bridge this gap?
  • What are the six value factors that can help us understand the potential impact of revisions in market expectations? How do we apply these value factors to understand how value triggers affect operating value drivers?
  • Which value triggers—sales, operating costs, and investments—affect which value factors—volume, price and mix, operating leverage, economies of scale, cost efficiencies, and investment efficiencies?
  • Which value factors affect which operating value drivers?
  • Are all expectations revisions created equal?
  • How does threshold margin affect the relative importance of the sales value trigger?
  • When do cost or investment value triggers dominate?

Essential Ideas in Chapter 3

  • To earn superior returns, you must improve your odds of correctly anticipating revisions in market expectations.
  • The expectations infrastructure—which stems from the fundamental value triggers through the value factors to the operating value drivers that determine shareholder value—should help you to visualize the causes and the effects of expectations revisions.
  • Sales growth expectations are your most likely source of investment opportunities, but only when a company earns above the cost of capital on its investments.


Chapter Errata

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