Similar to what I did for Trade Wars Are Class Wars, I wanted to share a few takeaways from a book I recently reread: Expectations Investing: Reading Stock Prices for Better Returns by Michael Mauboussin and Alfred Rappaport.
I will provide a brief summary of the book and share some interesting takeaways I had from reading it. Later this week, I will post my notes from the book. While written in 2001, this book has a flexible framework that is still very relevant for business analysis. On a recent podcast, Mauboussin mentioned he may update the book. Fingers crossed!
The book has a simple premise: stock prices reflect the sum of investor expectations at any point in time. To achieve superior returns, investors must calibrate and understand the expectations built into a stock price.
The authors advocate using a “reverse DCF” to determine expectations. In essence, a reverse DCF starts with the current price, backing into a set of cash flows that justify today’s price. You can start this forecast by using Wall Street consensus estimates and extend it out until you have enough years of free cash flow to get to today’s price. I would note the book has a website if you want to download the model and see it for yourself.
The book then provides a framework to analyze how a company creates value based on its value factors1. Next, the book goes into several frameworks to analyze both industry economics and competitive positioning such as Porter’s Five Forces, value chains, Clayton Christensen’s Disruptive Technologies framework, and others.
Finally, the book concludes with discussions of how corporate events such as mergers and acquisitions, share repurchases, and executive compensation can signal changes in expectations.
Mental Model for the Stock Market
This book dispels the notion that the stock market is “short-term” and explains that the market values stocks on long-term cash flow expectations. In 7 Powers, Hamilton Helmer says the same thing:
“In public markets, value is determined by and changes based on expectations of future free cash flows”. Just because prices move in the short-term doesn’t mean the market is short-term. This is just the market reacting to what current performance may indicate about future performance, continually reshaping future expectations.
The simple way to think about this is if the market is short-term, every stock would trade at 1x its earnings or cash flow, but they don’t. This implies the market takes a long-term view, but not necessarily the correct view. The difference between what happens and how the market views it shows where money can be made, a point the authors stress throughout the book.
The mental model I formed from reading this is the market values stock on long-term cash flow expectations, but allows investors to make short-term bets on long-term outcomes. The market provides liquidity so a short-term view can be expressed, but its still based on a long-term outcome.
Value Creation & Economics
I often hear words or phrases repeated so often they lose all meaning to me. For example, strategy used to be one of these words, but reading 7 Powers has help me clarify it in my mind a bit.
“Value Creation” is another one of these phrases. What does it mean? To me, creating value means creating benefits for the customer. However, any business can create benefits, but incurs costs to do so. In an economic context I define value creation as creating a positive spread between benefits and costs.
At a company level, it gets a little more specific. Is it enough to generate a positive spread between benefits and costs? The answer is no. If you borrow or raise money, investors expect to earn a return on that money you will be measured against. That is your opportunity cost of capital. If the return earned on your investments is less than that cost, you are not creating value.
Value Creation in the Company (ROIC)
In this book, the Mauboussin and Rapport explain that a company creates value when it invests at a rate that exceeds the cost of capital. How do you measure that rate? I believe return on invested capital (or “ROIC”) is a good place to start. So, just like above, you aren’t creating value in a business context unless you generate a positive spread between ROIC and the cost of capital.
To understand if a business is creating value you must understand its unit economics. What does this mean? I will let Mauboussin explain in a more recent piece he wrote as he says it much better than I can:
What is in an investor’s control is gaining a solid understanding of a company’s prospects for creating value. This requires a grasp of the basic unit of analysis, which answers the fundamental question of how a company makes money. The basic unit of analysis for Walmart, and other retailers, is the return on investment for a store. Net present value is the tried and true way to conduct this analysis. A store creates value if the present value of future free cash flows it generates exceeds the investment the company makes in it.Michael Mauboussin, “One Job”
Studying unit economics helps you figure out the return on one store, customer, or transaction.
This book provides a framework to assess company prospects for value creation by identifying its value factors, which drive its value triggers and value drivers. Value factors are the underlying drivers of revenue, cost efficiencies, and investment efficiencies. These value factors determine the value triggers of sales, operating costs, and investments. In turn, these value triggers imply the value drivers of sales growth rate, operating margins, and the investment rate. These variables drive expectations of future free cash flows.
Although the authors use a reverse DCF as the basis for investor expectations, they also acknowledge that not all value will be captured in a DCF. Sometimes, a company can have some of its value attributed to real options. Real options are business decisions to expand, defer, wait, or abandon a project which all have economic value.
The authors point out that you can analyze a company’s investing patterns to see if they exploit real options or contain some kind of embedded optionality. The book does a case study on real options using Amazon’s real option to further expand in the e-commerce market. When the book was published in 2001, Amazon had a market cap of $22 billion(!).
Amazon, the Real Options Machine
With the benefit of hindsight, Amazon has been a “real option machine” over the past twenty years. For instance, the birth of Amazon Web Services, reflects the idea of real options well. Amazon was having trouble scaling its IT resources quickly, so it organized its IT infrastructure into compute, storage, and database. It was quite good at it and invested heavily in it.
At some point, Amazon realized it could offer this business as a service, so its investments reflected embedded optionality to create a new line of business. Today, AWS may be the most valuable business Amazon has. They also seem to be in the early stages of doing the same thing with logistics($).
I don’t know if Amazon views it this way explicitly, but I am not sure they view costs as “costs”. What I mean is they look at large cost centers as an opportunity to offer services to others that will create not only offsetting revenue and but give them the ability to scale further, reducing units costs and enhancing scale advantages.
Inputs vs. Outputs
Mauboussin makes the point in this book and other places that multiples are not valuation. I’ve spent time in both investment banking and private equity, and more often that not, valuation is determined by some multiple range (usually chosen in reference to comps) applied to said metric. Slapping on a multiple on a metric confuses inputs with outputs.
What determines valuation multiples are the value drivers: sales growth, ROIC (driven by the operating margin and investment rate), and the discount rate.
Cash flows drive valuation and they can correlate to earnings, but are not the same thing. Earnings have a few weaknesses, with one of the most notable being they don’t account for opportunity costs nor investments in fixed and working capital.
Multiples in the context of M&A and Share Repurchases
Valuation multiples are not only bad for valuation work, but also for evaluating an acquisition or calculating the return on a share repurchase. Just because an acquisition is accretive based on multiples doesn’t mean it creates value. For an acquisition to create value, the present value of synergies must be greater than the premium paid. This makes sense: the present value of future benefits in a combination must be greater than the premium paid.
The same idea works for share repurchase. The return on a share repurchase is not the inverse of the P/E multiple. For example, if a stock has a P/E of 10, the return on a share repurchase is not 10%, or 1/10. The authors stress the return on a share repurchase must consider the cost of the capital and the discount at which the stock can be purchased relative to what management thinks its worth. For example, if a company has a cost of capital of 10% and stock that is trading for $8 a share, but management believes its worth $10, a share repurchase would have an an implied return of 12.5%2.
This framework is more robust as it implies there are diminishing returns to buying back stock. This would be true in cases where it trades above where management thinks its worth. Said another way, if management thinks its stock is overvalued it is probably the time to issue some!
I reread this book after reading it several years ago and came away with some rich notes I intend to post. Although its dated, a lot of the lessons are timeless and I suggest you pick it up.
Please provide any feedback below and I will update this post with a link once my notes are up.