š§ Expectations Investing - Calculating Market Expectationsš§
@mjmauboussin is one of the thought leaders that has most influenced my investing framework. His book "Expectations Investing" is a must-read for investors.
A thread on how to understand market expectations š
@mjmauboussin is one of the thought leaders that has most influenced my investing framework. His book "Expectations Investing" is a must-read for investors.
A thread on how to understand market expectations š
2/ Mauboussin wrote a paper nearly a decade ago about understanding PE multiples (valuewalk.com) from which I gained a deep understanding of the analysis below. I will elaborate more on this in a future newsletter.
3/ A critical component of my process, adopted from Mauboussin, is truly understanding market multiples and breaking them down into their component parts.
Through this, I am able to bifurcate company value into 1) steady-state value and 2) future growth value.
Through this, I am able to bifurcate company value into 1) steady-state value and 2) future growth value.
4/ This is important so that you can determine how much you are paying for future growth and more importantly if you have a materially different view from the market.
Why is expectations investing the optimal method for valuation IMO?
Why is expectations investing the optimal method for valuation IMO?
5/ Instead of trying to make assumptions to arrive at an estimate of value, you are really reverse-engineering the process/company value.
Simply, since we know the price (thus, value) of a stock, we only need to ask ourselves "what needs to happen for this price to make sense."
Simply, since we know the price (thus, value) of a stock, we only need to ask ourselves "what needs to happen for this price to make sense."
6/ This process illuminates the most important factors of company value - discussed further below:
1. Return on Incremental Invested Capital (ROIIC): The most important component of value creation. If ROIIC equals the cost of capital, then investments don't create any value.
1. Return on Incremental Invested Capital (ROIIC): The most important component of value creation. If ROIIC equals the cost of capital, then investments don't create any value.
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2. Illustrates the impact of growth/investments, which can be seen via the spread between ROIIC and cost of capital. So, if there is a wide spread in these figures, more rapid growth adds more value.
3. Thus, investors should focus on growth LAST.
2. Illustrates the impact of growth/investments, which can be seen via the spread between ROIIC and cost of capital. So, if there is a wide spread in these figures, more rapid growth adds more value.
3. Thus, investors should focus on growth LAST.
8/ Value creation relies on a company's ability to generate ROIIC > Cost of Capital, sustain this spread over time, & create future investment opportunities.
The time during which ROIIC is > cost of capital is the period of a company's sustainable competitive advantage.
The time during which ROIIC is > cost of capital is the period of a company's sustainable competitive advantage.
9/ Starting with thinking about firm value as I discussed above - steady-state vs. future growth values.
Steady-State Value
Important assumption: Current steady-state value can be sustained indefinitely & future investments don't add or subtract value (captured in growth value).
Steady-State Value
Important assumption: Current steady-state value can be sustained indefinitely & future investments don't add or subtract value (captured in growth value).
10/ Based on a study performed over 1961-2013, the steady-state accounted for ~67% of total company value on average. Before providing the calculation, understand the implied steady-state P/E multiple or cost of capital.
P/E = 1 / Cost of Capital
The historical avg PE is ~12.5x
P/E = 1 / Cost of Capital
The historical avg PE is ~12.5x
11/ Stead-State Value = Normalized NOPAT / Cost of Capital + Excess Cash
Normalized NOPAT utilizes a sustainable tax rate (Mature comps or est. 26-30% effective rate).
NOPAT is "Net Operating Profit After Taxes" which is operating profit assuming no leverage = EBIT * (1 - T %)
Normalized NOPAT utilizes a sustainable tax rate (Mature comps or est. 26-30% effective rate).
NOPAT is "Net Operating Profit After Taxes" which is operating profit assuming no leverage = EBIT * (1 - T %)
12/ Future Value Creation
There are three main drivers to future value creation:
1. Spread between ROIIC and cost of capital
2. Magnitude of investment
3. How long a company can find investment opportunities at this positive spread
*The first two points dictate the growth rate
There are three main drivers to future value creation:
1. Spread between ROIIC and cost of capital
2. Magnitude of investment
3. How long a company can find investment opportunities at this positive spread
*The first two points dictate the growth rate
13/ The one difficult aspect to predict is #3, duration of competitive advantage periods.
What I do is combine the company's narrative and competitive positioning with base rates. Historical calculations show the market implies roughly 6 years or more of this period.
What I do is combine the company's narrative and competitive positioning with base rates. Historical calculations show the market implies roughly 6 years or more of this period.
14/ Brett Olson estimated the average from 1976 - 2007 was about 8 years, with a minimum of 5 years in competitive industries and 15 in stable industries.
Step 1: Calculate ROIIC = (NOPAT @ t1 - NOPAT @ t0)/Investment @ t0
- NOPAT is calculated the same as above
Step 1: Calculate ROIIC = (NOPAT @ t1 - NOPAT @ t0)/Investment @ t0
- NOPAT is calculated the same as above
15/ Investment = Net Working Capital + Net PP&E (net of Depreciation) + Acquisitions
- This formula makes a VERY important assumption that all NOPAT growth is from the previous period's investments, which we know isn't necessarily true.
- This formula makes a VERY important assumption that all NOPAT growth is from the previous period's investments, which we know isn't necessarily true.
16/ Step 2: Calc Future Value Creation = [Investment * (ROIIC - cost of capital) * competitive advantage period] / [Cost of Capital (1+Cost of Capital)]
Subtract the SS value from the current EV to calculate what the market is pricing in for future value creation.
Subtract the SS value from the current EV to calculate what the market is pricing in for future value creation.
17/ Comparing the implied value in the market to the future value I calculated can give insights into if the market is under or overestimating firm value. This is the first step to generating alpha. I posted an image of my simple analysis below:
18/ Conclusion / Analysis
Here's a snapshot of the analysis. What are your thoughts on this process?
Here's a snapshot of the analysis. What are your thoughts on this process?
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