In their book – Expectations Investing: Reading Stock Prices for Better Returns, Michael Mauboussin and Alfred Rappaport discuss how to use the expectations investing process. Here’s an excerpt from the book:
THE EXPECTATIONS INVESTING PROCESS
In the following chapters, we’ll walk you carefully through the three-step process of expectations investing.
Step 1: Estimate Price-Implied Expectations
We first “read” the expectations embedded in a stock with a long-term discounted cash-flow model. We thus reverse the common practice, which begins with earnings or cash-flow forecasts to estimate value. The benefits of this reverse engineering include the following:
• The long-term discounted cash-flow model is the right tool to read expectations because it mirrors the way the market prices stocks.
• Expectations investing solves a dilemma that investors face in a world of heightened uncertainty by allowing them to harness the power of the discounted cash-flow model without forecasting long-term cash flows.
Step 2: Identify Expectations Opportunities
Once we estimate current expectations, we then apply the appropriate strategic and financial tools within a tightly integrated competitive-strategy analysis and finance framework to determine where and when revisions in expectations are likely to occur. Here are the advantages of this approach:
• Expectations investing methodology reveals whether the stock price is most sensitive to expectations revisions in the company’s sales, operating costs, or investment needs so that investors can focus on the potential revisions that affect price most.
• Expectations investing applies the best available competitive strategy frameworks in the investor’s search for potential expectations revisions.
• Expectations investing provides the tools to evaluate all public companies—old and new economy, value and growth, developed and emerging market, start-up and established. Expectations investing applies universally.
Step 3: Buy, Sell, or Hold?
Finally, the process defines clear standards for buy and sell decisions. Central features include the following:
• Prospective buys or sells must offer a clear-cut “margin of safety.” A buy candidate, for example, must trade at a sufficient discount to its expected value.
• Key insights from behavioral finance help investors avoid decision making pitfalls.
• The use of demanding buy and sell hurdles reduces transaction costs and income taxes.
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