Book Reviews, Value Investing

Book Review: Expectations Investing by Alfred Rappaport and Michael Mauboussin

Rating: Mama desu

Background: One book that I read probably 1-2 years ago. With all these stuff about efficient market hypothesis and stock prices fully reflecting all publicly available information, the book’s catchy caption “Reading stock prices for better returns” caught my attention, as to what you can glean from the current stock prices.

Key points:

  1. The book’s main procedure goes like this:
    1. Use the consensus analysts’ earnings growth rates to project future earnings.
    2. Use WACC as the discount factor.
    3. Use the rate of inflation (e.g. around 3%) as the growth rate for calculating the terminal value.
    4. Use the current stock price as the solution for the DCF.
    5. Solve for the implied “competitive advantage period”, i.e. the number of years of “good growth” before hitting the terminal value.
    6. So now, you have the complete “market model” for the stock, i.e. how the market expects the company to perform.
    7. Now perform a competitive strategy analysis for the company (e.g. using Michael Porter’s 5 forces model). Anticipate how expectations will be revised for the primary drivers (i.e. Sales growth, operating margins, re-investment) due to the competitive dynamics. For example, sales growth expectations may change due to changes in volume, selling prices and product mix; operating margins may change due to selling prices, product mix, economies of scale and cost efficiencies. You can see a diagram of the “expectations infrastructure” here (exhibit 3).
    8. Calculate a new expected value of the stock by factoring in your predicted changes in the expectations of the drivers (and their corresponding impacts on the inputs of the DCF).
    9. Buy/sell stocks that trade at sufficient discounts/premiums from their expected values.
  2. Include future option grants when estimating future costs.
  3. When an acquiring company uses cash, it signals that their own stock is undervalued. On the other hand, if they use stock, it signals that their own stock is overvalued.

Thoughts: While the idea is interesting, I don’t really subscribe to it. I don’t subscribe to EMH and I don’t believe that the market indeed have a consistent view of how DCF should be done, with the competitive advantage period being the flexible variable in question when doing the reverse DCF.



2 thoughts on “Book Review: Expectations Investing by Alfred Rappaport and Michael Mauboussin

  1. I believe the Alfred Rappaport and Michael Mauboussin procedure described in the review is well thought out, assuming “the competitive strategy analysis for the company (e.g. using Michael Porter’s 5 forces model)” recognizes that most companies are made up of many businesses and, therefore, requires a weighted average of the company’s strategic business units. (Our research has shown that the largest 1,000 global companies by revenue compete, on average, in approximately 72 industries, where “industry” is defined as the correct level to perform a Michael Porter analysis. Example industries include: mainframe computers; frozen pizza; home insurance; and wholesale funds transfer services.)

    Posted by Alan S Michaels | July 30, 2007, 4:04 am
  2. Yes, I do agree that using competitive strategy analysis on companies is a good way to analyse companies.

    What I’m not comfortable about with Alfred Rappaport and Michael Mauboussin’s method here is their assumption of EMH, and then using that assumption to calculate an implied competitive advantage period. Firstly, if you don’t subscribe to EMH, the whole thing falls like a pack of cards. Secondly, even if you subscribe to EMH, you have to believe that everybody does DCF in the manner that they do, i.e. everybody uses the rate of inflation in the calculation of the terminal value, everybody uses the earnings growth rate estimates from the analysts, etc.

    That’s my reasoning of why the entire method used as a whole may not work out. It would be helpful if the authors can also produce some results of a portfolio that was managed using this process.

    Posted by whatheheckaboom | August 5, 2007, 9:56 am

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