A revised and updated Expectations Investing by Michael Mauboussin and Al Rappaport was released in 2021 by Columbia University Press and it’s the best investing book I’ve ever read! Period.
As the Head of Investor Training and Development at The Motley Fool, I am recommending that our entire team read this fresh update from these investing experts. Mauboussin is the Head of Consilient Research at Counterpoint Global, a division of Morgan Stanley , and a professor at Columbia Business School. Rappaport is the Leonard Spacek Professor Emeritus at Northwestern University and the author of one of the most important corporate finance and valuation books, Creating Shareholder Value. Michael Mauboussin, left, and Al Rappaport are the authors of the book “Expectations Investing.” Image source: Michael Mauboussin and Al Rappaport. I’ve now read Expectations Investing three times, the original version once over a decade ago, and the updated edition twice. I also own two copies of the new edition, one with all my markups and highlights, and another unmarked version that I may lock away in a safe for posterity’s sake. Not only is it the best investing book I’ve read, but Mauboussin and Rappaport have launched a website that offers 10 free tutorials, including a reverse discounted cash flow (DCF) spreadsheet that investors can use to calculate the price-implied expectations (PIE) baked into a stock price. As a value investor, I’m not aware of a better deal on the market than a free spreadsheet created by these two stars.
I was so excited after reading the book that I decided to reach out to the authors to ask some follow-up questions. It’s been a while since I’ve interviewed Michael , but Mauboussin and his mentor Rappaport said they were willing to do an interview and offer me (and you) some additional insight on Expectations Investing .
What follows is my written question-and-answer session with the two men.
Question: Can you please define “expectations investing” and give us an overview of the steps of the process/framework?
Answer: In a nutshell, expectations investing reverses the traditional approach to assessing whether the stock of a company might promise superior returns. Most investors make an estimate of value and then compare it to the current market price. Expectations investing starts with what we know, the stock price, and asks whether the expectations for the company’s financial performance implied by the stock price are justified.
There are three steps in the process. We first put the consensus expectations into a long-term discounted cash flow model and solve for the forecast horizon that justifies the stock price. The essential determinants of value include the cash flows of the business and the opportunity cost of capital.
Second is to do a historical and strategic analysis to judge the likely performance of the company. Here we like to think in scenarios and to invoke base rates. The product of this step is an expected value for the company’s shares.
Finally, the difference between the expected value and the price provides guidance for buy, sell, or hold decisions. Here we also take into consideration other issues such as taxes.
Q: What is the goal of investors using the Expectations Investing framework?
A: The goal is to identify securities with superior return prospects. Because stock price changes are the result of revisions of expectations, we believe that getting a fix on current expectations and anticipating how expectations will change is a useful approach to security selection.
Q: What is a variant perception and what is your definition of an attractive investment thesis?
A: Variant perception is holding a well-founded view about a company’s financial prospects that are not priced into the stock. In other words, your expectations and the expectations implied by the market are different and noteworthy.
An attractive thesis, therefore, would be one where you can identify the specific differences in expectations. For example, you have an attractive thesis if your strategic and financial analysis suggest that operating profit margins will rise when the market has priced in a decline, all else being equal.
Q: What is the difference between estimating fair value using a discounted cash flow (DCF) model and using a reverse DCF?
A: The valuation model is the same, of course, but in order to estimate fair value an investor needs to make forecasts about value drivers such as sales growth, operating profit margins, investment needs, and the number of years the company will generate returns above the cost of capital. With a reverse DCF […]
source Expectations Investing: A Q&A With Michael Mauboussin and Alfred Rappaport
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