on April 5, 2002
When I started working on Wall Street ten years ago, I thought my colleagues would be fantastic stockpickers who used intelligence, foresight, and brilliant paradigms to pick great stocks.
The last decade has taught me that most Wall Street analysts are very intelligent. However, I must report that as a whole, they have *no idea* what they're doing. I'm not sure how it happened, but most investors have come to believe in a hodge-podge of rules-of-thumb that "everyone knows" but nobody can explain. Arbitarily, "growth" investors tell us to "Buy stocks that grow their earnings faster than their P/E multiples!" Just as randomly, "value" investors tell us to "Only buy stocks with low P/E's with lots of book value!" If you try to integrate all these rules of thumbs into a single mental model, you have to make so many exceptions to every rule that your mind feels like Swiss cheese.
In contrast, this book offers a clean, intelligent FRAMEWORK for thinking about investing in anything that produces a stream of future cash flows (including stocks, of course). It's the investing Bible I wish I had when I started my career. It would have shaved years from my investing education, and saved me from numerous migraines.
The book starts with the same first principles you read in your Corporate Finance textbook, makes relevant the practical arcana you learned in Accounting class, and incorporates Porter's and other strategy frameworks into valuation. The book presents a CLEAN and FLEXIBLE way of thinking about stocks. For example, you can apply their approach to Dell from its IPO to today -- and get useful data that would help with a Buy/Sell decision. Traditional value investing would have had you out of the stock way before it was a ten-bagger, and momentum investing would have whipsawed you in and out of the stock with no rhyme or reason.
Don't get me wrong, though. Rappaport and Mauboussin haven't invented a new Theory of Investing tabula rasa. What they've done is integrate the best of academic research and practical finance into a single framework. And they've written great additional material, like the chapter on M&A (which is better than the entire Sirower "Synergy Trap" book) that presents an approach to analyzing deals sensibly. And the chapter on Employee Stock Options is critical to valuing tech companies, but isn't even covered in the McKinsey Valuation book, Quest for Value, and other books I've read.
If you want a confusing investing book full of fun (but useless) war stories, read the fictional Reminiscences of a Stock Operator or 99.9% of nonfiction investing screeds. Until Warren Buffet writes his book, if you want something that can help you invest intelligently and avoid headaches, this is the book to buy.
Note: People who already know (or are willing to learn) how to analyze a company's financial statements will get the most from reading this book.
on October 31, 2001
You can read this book in a number of ways:
1. TAKE JUST WHAT YOU NEED. Even though I'm a valuation expert, I thought some chapters of this book stood out as just plain useful. Chapters with great standalone value include: (A) Chapter 8 on Real Options, which develops the only framework for applying real options that I've seen that's intuitive; (B) Chapter 10 on M&A analysis which gives a solid treatment of all deals including often-ignored fixed-value stock deals; and (C) Chapter 5 Appendix on Employee Stock Options which explains how ESOs affect valuation (this is ignored by every other book on valuation). Moreover, I found the tutorials and spreadsheets at the expectationsinvesting.com web site made it easy to apply these ideas without hours of tedious spreadsheet work.
Some chapters may be more or less applicable to various readers. For example, investors may find Chapter 11 on incentive compensation to be more applicable to managers. Also, Chapter 4 is most beneficial to those who haven't read the strategy frameworks of Michael Porter, Clayton Christensen of INNOVATOR'S DILEMMA, and Varian/Shapiro of INFORMATION RULES.
2. USE "EI" TO PICK STOCKS. Chapters 5, 6, and 7 lay out the "EI approach" to investing. Namely, the authors suggest that investors use a DCF approach to reverse engineer consensus expectations from a company's current stock price. Then, the authors suggest you compare YOUR expectations to CONSENSUS/MARKET expectations. If you think market expectations are low, buy the stock. If you think market expectations are too high, sell or short the stock.
At first glance, it might seem that this material has already been covered in McKinsey's VALUATION or Damodaran's valuation library. But those books don't deal with two things: (A) the importance of the "forecast period" and its relation to strategy and competition, and (B) the importance of figuring out market expectations. Thus, even though I've read those and other books, I learned a lot in this section.
3. TO LEARN HOW TO THINK ABOUT INVESTING. I'd also recommend this book to someone who had a smattering of financial knowledge, but was confused by the contradictory smorgasbord of investing theories out there. Any MBA -- or any determined individual investor who can read a balance sheet -- would find this to be a great foundation book. You could use other more detailed books to fill in the cracks, but this is the best place to start.
An interesting read for the serious investor. The central tenet of the book might be stated as "investors do not earn superior rates of return on stocks that are priced fully to reflect future performance - even for the best value-creating companies - which is why great companies are not great stocks." This book posits that investors can read market expectations contained in a stock's price and anticipate revisions in those expectations to achieve superior returns. It book provides a detailed, step-by-step way to accomplish this process.
"Expectations Investing" is divided into three parts. Part I details how to determine the expectations for a stock based upon its current market price. Interestingly, rather than determine a "fair price" based upon a company's free cash flow, the book turns this process upside down, using a company's stock price to determine the market's expectations for free cash flow going forward. Next, the book helps identify "expectations opportunities" - places where revisions in the stock market's expectations are likely to take place. By focusing on key areas where expectations opportunities may take place (so-called "turbo triggers"), the skilled investor can modify their discounted cash flow projections to determine the appropriate price. This section further provides a framework to determine when to apply buy, sell, and hold decisions. Lastly, Part III of the book explains how certain, specific corporate events (mergers, share buybacks, and incentive compensation) may signal that expectations revisions are in order.
Within the book itself, I found the chapter on "Analyzing Competitive Strategy" to be an outstanding, investor-focused distillation of many of the points contained in Porter's "Competitive Strategy." Moreover, the chapters on specific corporate events were interesting insofar as they explain, in greater detail than I had read before, the quantitative analysis that underlies decisions related to mergers, share buybacks, and incentive compensation.
Potential readers should be aware that the authors of this book, like many stock analysts, adhere to the so-called "Capital Asset Pricing Model" school of thought (that the value of a security equals the rate on a risk-free security plus a premium, beta, which is determined based upon the volatility of the security in question). This model is just one of many that investors may use. Moreover, although stock analysts may have access to customers, creditors, competitors, and company insiders, many individual investors will lack those contacts, and thus face some difficulty in determining possible expectations revisions. Even if an investor had access to such information, the developing field of behavioral finance (see Belsky and Gilovich, "Why Smart People Make Big Money Mistakes" as but one example) would caution that investors seeking to implement the methods set forth in this book need to be careful of confirmation bias (tending to view information in a way that supports their pre-determined preferences) and information cascade (too much information), among others.
Lastly, readers should be aware that modeling out the process described by this book requires some math, and the ability to create spreadsheets of middling-level complexity. This is not a "buy low P/E" book - readers will have to do their homework to use these methods. Anyone who isn't looking to put several hours into investigating each stock they are interested in should look elsewhere.
In all, this is a well-written book that makes a very complicated process relatively simple. It is not designed for the casual reader, and implementing the expectations investing process certainly takes considerable work. However, the book provides valuable insights into how analysts function and how stocks are priced by public markets.
However, if forced to pick a well-written, fairly sophisticated book on investing, I'd recommend a few other books ahead of this one, including "Security Analysis" by Benjamin Graham and either of Martin Whitman's books ("The Aggressive Conservative Investor" or "Value Investing").
on January 23, 2010
Why don't average investors use discounted cash flow analyses? Typically, they don't use them for several reasons.
* Most people don't want to use an algebraic formula to estimate anything. As some legendary trader reputedly yelled at a quant, "No formulas! You can make me add, subtract, multiply, and divide!... And don't make me to divide too often!"
* It is not intuitive to most. It takes a bond-like or actuarial approach to analyzing stocks -- forecasting future free cash flows and discounting them at the firm's cost of capital.
* It is highly sensitive to assumptions one employs. Small changes in growth rates or discount rates can make a big difference in the estimate of value. It lends itself easily to garbage in, garbage out. (I remember a Dilbert cartoon where an analyst told Dogbert that scientific decision analysis required forecasting future free cash flows and discounting them. He added that the discount rate had to be right or the analysis would be garbage. Dogbert's comment was to the point: "Go away.")
* It takes a lot of work, and shortcuts are easier, providing most of the analysis with less effort.
Now, most professional investors don't use DCF either, for many of the above reasons. But there are a number that do, among them Buffett. Morningstar uses DCF for its stock recommendations. It's not a bad system after one makes the effort as an organization to standardize your free cash flow estimates and discount rates. Most professionals invert the process, and rather than trying estimate what a stock is worth, they estimate what they think the company will return at the current market price.
Expectations Investing is one way to formalize DCF, and a rather comprehensive one. It would be a good way for an investment organization to formalize its investment process, but is way too complex for one person implement, unless one is following some type of simplifying system like Morningstar, ValuEngine or any of the other purveyors of DCF analyses out there.
In the process of formalizing DCF, the book explains the problems with traditional P/E analysis, and how a focus on free cash flow can remedy the problems. A weak spot in the book is their discussion of cost of capital. Their cost of equity capital analysis relies on beta, which is not a stable parameter, nor does it really capture what risk is. That said, inverted DCF can work without discount rates. The book takes the approach that the discount rates are the less critical factor, because when they change for one firm, they typically change for all firms. The book's solution is to use current prices to drive DCF backwards and determine market free cash flow expectations for a stock.
The analyst can then look at those expectations, and try to determine whether they are too high or too low. The analyst can also look at whether there might be changes due to unit growth, product price changes, operating leverage, economies of scale, cost efficiencies, and changes in the marginal efficiency of capital. After the analysis, usually one or two factors will stand out capturing a large portion of the variability. The analyst then focuses on those, and what drives them. Unexpected changes lead to revisions to the analyst's model, and the game continues.
Beyond that, the analyst needs to understand how the company in question fits into its industry. The book discusses Michael Porter's five forces, the value chain, disruptive technologies, and the economics of information. Beyond that, the book touches on:
* Real Options -- the ability of a company to pursue value enhancing projects or not.
* Buybacks -- do them when the company has no better opportunity, and the shares are undervalued.
* Mergers and Acquisitions -- how to tell when are they good or bad ideas.
* Reflexivity -- Are there situations where a higher or lower stock price affects the business? High/low valuation makes financing easy/difficult.
* Understanding management incentives -- how will they affect financial results and management behavior over the short and long runs.
At 195 pages in the body of the book, Expectations Investing is not a long book for what it covers. The flip side of that is that is breezes over much of the complexity inherent in what they propose. One other shortcoming is that little time is spent on financials, which are a large part of the market, and for which it is intensely difficult to calculate free cash flow. After reading the book, I would have no idea on how to apply their DCF model to valuing a bank or an insurance company.
Aside from financials, if someone were to ask me, "Is this how valuation should be done?" I would say, yes, ideally so. But it brings up one more critique: though I hinted at it above, most of the shortcuts that investors use are special adaptations and first approximations of the DCF model. That is why shortcuts have validity -- if you know the critical factors that drive profitability for a given company or industry, why waste your time on a big model with many inputs? Cut to the chase, and use simpler models industry by industry.
Who would benefit from this book: someone who either wants a detailed means of calculating a DCF model, or a taste of the issues that an analyst/investor has to consider as he evaluates the worth of a company's stock.
This is a neutral review from me. I neither encourage or discourage the purchase of the book. It has its good and bad points.
on January 20, 2002
Rappaport and Mauboussin expertly utilize the often misapplied DCF model to identify and analyze market assumptions that determine stock price. In the age of irrational exuberance, the disparity between market value and intrinsic value is often dismissed as the product of a fickle and unpredictable market. Rappaport and Mauboussin, however, remind us that the market is indeed rational in the long term and changes in stock prices are the result of changes in market expectations. The "Expections Investing" methodology helps investors to understand current expectations and anticipate expectation revisions.
A financial model is only as good the assumptions behind it. The forecasting process invariably reflects the assuptions of the analyst, which tend to be biased by experience and preconception. "Expections Investing" teaches investors to avoid predilection by reverse engineering DCF models from stock prices, allowing them generate figures that reflect market assumptions rather than their own.
This value-agnostic process produces greater accuracy in many areas that are frequently overlooked. Rappaport and Mauboussin expose the fallacious nature of models based on forecast periods and discount rates that are assigned in an arbitrary fashion. They correctly state that the finger-in-the-wind approach is not sufficient and can greatly distort the final analysis. "Expectations Investing" also highlights topics (i.e., valuation of employee stock options) of which the significance is often underestimated or ignored in traditional valuation analysis.
on October 25, 2001
This book should be required reading for every active investor today. Too often pundits throw out terms like market leader,growth stock, value stock, recession resistant as reasons to buy a stock, and try to predict where the "market" will go for the next six months. Expectations Investing will help you learn to throw away these lazy investor labels and instead provides a framework for evaluating a particular stock in terms of what the current price is saying about how good or bad the future for the company may be and whether it merits your purchase or sale. You will learn that every stock, market leader or not, has a whole set of assumptions embedded in the current valuation- this book will help you learn to think in these terms and evaluate whether those assumptions embedded in the current price are reasonable. The book debunks some popular myths and provides highly illustrative examples that make some technical issues easy to understand. For the pro, coverage of executive compensation, option analysis as well as key chapters on competitive strategy and other operating issues will definitely stimulate the thought process. At the same time the basics of valuation are covered in an easy to read fashion. Finally, the Notes section itself can lead the intellectually curious to a "pot of gold" of information. Turn off the business TV and put your popular financial magazine on the coffee table and read this book instead !
on April 1, 2002
"Expectations Investing" presents a powerful idea - From a company's stock price, derive what the market is expecting of the company's performance. Then, based on your own expectations, decide if the stock is a worthy investment. One might say, isn't this what investors do all the time, using multiples like P/E? The book talks about the drawback of such multiples. Then it presents a clear and elegant framework to identify the true drivers of a company's value. You need to perform a strategic analysis of the company and industry to identify the plausible ranges for these value drivers. You can see where your assumptions stand with respect to market expectations (which you reverse engineer from the stock price and consensus estimates for future performance). You assign probabilities to various outcomes based on your convictions, and decide to buy/sell.
In 195 pages, this book presents a bunch of insights. The presentation on valuing a company's stock options, as well as discussion of value capture by buyers/sellers in mergers and acquisitions, are the clearest I've seen in any finance/valuation book. The discussions on incentive compensation, as well as management signals in share buybacks, are also quite impressive and accessible to the general reader. The accompanying website for this book is highly complementary, and presents excel models for all topics covered. I adapted them for a sample company and was quite delighted! While DCF valuations are not every investor's cup of tea, this book goes the farthest in trying to make its DCF-based framework manageable by the average person.
Now for the caveats which I hope are minor - A couple of earlier chapters pack the gist of several MBA classes (corporate finance, strategy, behavioral finance). If you are not an MBA, the profoundness of the ideas might be lost on you in the rat-a-tat-a-tat rapid fire presentation. Also, you will appreciate this book better if you have some conceptual understanding of corporate finance, such as cost of capital issues.
on October 2, 2001
Alfred Rappaport is a wide acknowledged founder of the shareholder value approach. Michael Mauboussin is a respected strategist at CSFB, a respected investment banking firm. Together, they wrote a book which is simple and intuitive to read for people with a financial background or a strong interest in different aspects of corporate finance. A good grisp of the DCF approach is a minimum requirement. (you could start with creating shareholder value of A. Rappaport to get up to date)
Both authors start by explaining why investors place short term bets on the Long term future of stocks... Some companies are victim of the expectation treadmill and saw there stockprices decline rapidly as a result (90% of the TMT companies). The good thing about the book starts after this intro which is refreshing but not new. The second part links the number crunching part with interesting frameworks for competitive analysis. The fundamental law of investing might be the uncertainty of the future, but the frameworks at least will give you the tools in trying to be a visionair. because being a visionair is the only way you can beat the index. An investor does not only need to find good companies. He/she also needs to know the expectations already embedded in the stock price. The third part gives a couple of examples when these expectations might change and how to react (buy or sell). This book will be the start of a standard type of analysis in the next decade. I will try to start in the Netherlands...
Many economists and finance professors argue that discounted cash flow accurately captures the value of all stock prices. If you believe that, you will find this book to be a five star effort. If you believe that discounted cash flow has little to do with stock prices, you will find this book to be irrelevant.
As those who calculate discounted cash flow know, you can calculate a discounted cash flow or you can examine a price for a security and deduce what assumptions would lead to that value being correct. Expectations Investing argues for the latter approach, on the grounds that it is easier to do than creating a discounted cash flow. I did not notice all that much reduction in effort.
The book is very thorough in explaining how to interpret stock prices in terms of discounted cash flow perspectives, and those who are not familiar with this technique will find the book to be filled with clear prose and examples.
When the NASDAQ was over 5000 last year, many people were still buying technology and dot-com stocks. Momentum investing encouraged them through “bullish” stock-price charts. Any approach to looking at fundamental value would have suggested that most stocks exceeded a “normal” valuation by at least 100 percent. Caution would have been instilled in some, perhaps.
I seriously doubt if very many individual investors will use this methodology. It is similar to one that a number of institutional investors use, based on data values calculated by a well-known valuation consulting firm (not one connected to either co-author here). I suspect that most people will simply buy the data and the analysis. If that’s the case, you won’t really need this book.
The authors argue that knowing the assumptions built into a stock price can improve investing results. But if everyone does this, will any more people outperform the market? I don’t know, but I’m skeptical. (...)
Over a period of 10 years, over 90 percent of professional investors and a higher percentage of individual investors will trail the popular indices, like the Standard & Poor’s 500. If you have the hubris to think you can do better, good luck! My own guess is that it would make more sense to buy Berkshire Hathaway stock and bet on Warren Buffett than on this methodology to beat the averages. Buying low-cost indexed mutual funds will still provide the best combination of good return, safety, and good sleep at night . . . as the co-authors accurately point out.
on October 4, 2001
In an investment world filled with tinsel and glitter, Rappaport and Mauboussin have given us substance and common sense. Using the invaluable information imbedded in the price of a stock to establish the market's expectations,the authors present a (fairly) simple methodology for assessing the valididity of those expectations, and to invest accordingly, It is, as Peter Bernstein says in his brilliant foreword (an absolute must- read before you plunge into the text), "a logical path to the heart of value."
I'm pleased to have give the book an earlier endorsement, because I hope that mutual fund managers will learn from "Expectations Investing" that there are far better ways to manage money--ways to focus on "value" whether their style is value or growth--than the costly, high-turnover, momentum-driven strategies that are rife in the industry today.
More than ever after the 35% fall in the stock market since March 2000, investors need wisdom. They'll find it here.