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.
- The book’s main procedure goes like this:
- Use the consensus analysts’ earnings growth rates to project future earnings.
- Use WACC as the discount factor.
- Use the rate of inflation (e.g. around 3%) as the growth rate for calculating the terminal value.
- Use the current stock price as the solution for the DCF.
- Solve for the implied “competitive advantage period”, i.e. the number of years of “good growth” before hitting the terminal value.
- So now, you have the complete “market model” for the stock, i.e. how the market expects the company to perform.
- 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).
- 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).
- Buy/sell stocks that trade at sufficient discounts/premiums from their expected values.
- Include future option grants when estimating future costs.
- 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.