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Excerpts from the Book > Chapter 5

Chapter 5 : How to Estimate Price-Implied Expectations

Excerpt from Chapter 5

As an investor, to earn superior investment returns, you must correctly anticipate the stock market's expectations revisions. But before you can consider the likelihood and magnitude of expectations revisions, you need to clearly understand where expectations stand today.

Ask an average group of investors if they are interested in reading market expectations and you'll hear a resounding "yes." But if you ask them how they go about reading the market, they'll probably fall back on a slew of contemporaneous, statistical benchmarks like short-term earnings and price-earnings multiples. While ubiquitous, these investments shorthands aren't reliably linked to shareholder value, so they simply don't paint an economically sound picture of today's expectations.

To accurately read the expectations wrapped in stock prices, you must think in the market's terms. The long-term discounted cash flow model best captures the stock market's pricing mechanism. Yet investors justifiably think forecasting distant cash flows is extraordinarily hazardous. Credible long-term forecasts are difficult to make, and they often serve to only reveal the forecasting investor's underlying biases. As Warren Buffet says, "Forecasts usually tell us more of the forecaster than of the future." Where then do you turn?

The ideal solution allows you to retain the discounted cash flow model but frees you from the burden of cash flow forecasts—which is precisely what expectations investing does. Instead of forecasting cash flows, expectations investing starts with the current stock price and uses the discounted cash flow model to "read" what the market implies about a company's future performance. This estimate of price-implied expectations (PIE) launches the expectations investing process.

Questions Addressed in Chapter 5

To walk through the theory and practice of estimating price-implied expectations (PIE), Chapter 5 answers the following questions:

  • How can we use different sources—such as Value Line Investment Survey, Standard & Poor's, Wall Street reports (available directly or via services such as Multex.com)—to establish a market consensus forecast for operating value drivers—sales growth rate, operating profit margin, and incremental investment rate?
  • What are some good sources to help us estimate the company's cost of capital?
  • How do we estimate a stock’s market-implied forecast period?
  • Companies with lots of knowledge workers often grant large numbers of Employee Stock Options. How do we account for the effect on value of already-granted options?  How do we account for the cost of future option grants?
  • How can we apply this process to a case study, such as analyzing Gateway's Price-Implied Expectations?

Essential Ideas in Chapter 5

  • Before you can consider the likelihood and magnitude of expectations revisions, you need to clearly understand where expectations stand today.
  • To read expectations properly, you must think in the market's terms. Expectations investing allows you to tap the benefits of the discounted cash flow model without requiring you to forecast long-term cash flows.
  • You can estimate price-implied expectations by using publicly available information sources.
  • You should consider revisiting an expectations analysis when stock prices change significantly or when a company discloses important new information.


 

Chapter Errata

Please contact the authors via e-mail if you have found a potential erratum in the book.

List of Errata in this Chapter

  • The ninth line of Table 5-1 on page 75 reads "Cummulative value of residual value." The line should read "Cummulative value of free cash flow."

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