Expectations Investing

Skate where the puck is going.
This book makes the argument for (1) working backwards from stock price to reveal expectations that are already embedded, then (2) assess the likelihood of expectations. Earnings growth does not tell the full story as earnings can be grown using ROIC > cost of capital, at the cost of capital, or below cost of capital. Thus, we depend on discounted cash flow analysis well into the future.

The Tools
There are operating drivers: (1) sales growth, (2) operating profit, and (3) fixed and working capital investment rate. There are also operating determinants: cash tax, and cost of capital. Sales growth rate, operating profit and the cash tax are needed to calculate NOPAT. Less fixed capital and working capital investments gets you to FCF.

  • Make sure you use cash tax, not accounting tax.
  • Fixed capital = CapEx + depression expense.
  • Working capital = Current assets - current liabilities.
  • Note: FCF is not changed by intangible accounting.
  • Note: terminal value can be perpetuity, perpetuity w inflation, perpetuity w partial inflation, or perpetuity with decline.
The Tools

Value factors
Volume, price and mix, operating leverage, economies of scale, cost efficiencies, and investing efficiencies. Sales is the most important trigger above because it effects the first 4/6 of these factors.

Competitive Strategy
Historical strategy must be reviewed first. Find the operating drivers that vary the most. Think of strategy at 3 levels: (1) industry landscape, (2) industry structure, and (3) firm specific.

Industry landscape:

  • Create industry map with customers on the left, company in the middle, and customers on the right. List all other companies that could have an impact on profitability. New entrants? Labor relations? Geopolitical risks?
  • Chart a value pool analysis: the competitors with market share on x-axis and operating margin less cost of capital on the y-axis. If you check these over time, a lot of change indicates limited competitive advantages.
  • Industry stability: Check market share over 3-5 years apart to determine how much change there has been.

Industry analysis

  • Five forces analysis, Michael Porter: Substitution threats, Buyer power, Supplier power, Barriers to entry, Rivalry among firms.
  • Disruptive innovation, Clayton Christensen: Concern for market leaders, centralized decision making, and companies that employ physical goods (to be disrupted by digital).

Firm's strategy

  • Two options to add value: Differentiation to be able to charge more, or low cost.
  • Value chain analysis: R&D, Managing supply chain, operating sales force, marketing and sales, and post sales service. Compare the company to industry and identify drivers of price, differentiation, and costs. Try to determine if costs add value.
  • Information economics: Account for high up front costs and low incremental costs in intangible based industries. Evaluate network effects, and the rate of lock-in.
  • Customer based corporate valuation (CBCV): Cost to acquire customer vs cash flow NPV from average customer.

Implementation:

  • Find a source to estimate: Sales growth rate, operating profit margin, cash tax rate, and incremental investment rate (fixed and working).
  • Calculate cost of capital
  • Financial health: Non-operating assets and debts review.
  • Implied forecast period: Dependent on implied FCF and cost of capital.

Find the turbo trigger. Estimate high and low values for sales and calculate shareholder value for each scenario. It will almost always be sales, but also check costs and investments.

Try to drill down to what leading indicators will affect the turbo trigger for a given company / industry. ***Will need to revisit this on keywords to look for.***

Pitfalls: Over precision, and confirmation bias (don't dismiss opposite opinion).

Paul Weaver

Charlotte, NC