Expectations Investing is a framework developed by Professor Michael J. Mauboussin of Columbia University and aims to work backward on the Discounted Cash Flow Model (DCF) to find the expectations baked into a stock price. Mauboussin believes the current valuation system isn’t able to sustain accuracy, as the Global Economy has had a major shift from tangible investments to intangible investments. Typical accounting methods can’t account for these types of stocks and thus misrepresent a company’s valuation. The Expectations Investing framework aims to resolve this issue to accurately find a company’s valuation.
The framework can be divided into 10 Key Steps and 4 Stages.
The first step is simply finding the current sales level of the company, and then finding the expected sales growth rate. This can be found in a variety of sources, but Mauboussin recommends using the company’s own published literature.
The second step entails finding the Operating Profit Margin, which is simply the amount of cash left over after subtracting only these expenditures from sales:
Step three is simply taking our Operating Profit and subtracting the Cash Tax, obtaining our Net Operating Profit After Taxes (NOPAT).
Step four is rather long, and involves finding the Incremental Investments.
The Incremental Working Capital can be found by using the cash flow statements and summing the following items:
Then the following items can be subtracted:
We must then find the proportion of cash used up in working capital for every new dollar of revenue, giving us a percentage for the Incremental Working Capital Rate.
To find the Fixed Capital, the following calculation must be completed where the following items on the cash flow statement must be added.
However, before a final figure is calculated we must subtract depreciation, as we want to calculate the cash invested beyond annual depreciation.
We must then find the proportion of cash used up in fixed capital for every new dollar of revenue, giving us a percentage for the Incremental Fixed Capital Rate.
Multiplying the projected cash increase in sales by the Incremental Working Capital Rate and adding this to the projected cash increase in sales times the Incremental Fixed Capital Rate to obtain the Incremental Investments.
We are now ready to calculate Free Cash Flow, which is our NOPAT minus Total
Excess cash reserves and securities account for the most value of non-operating assets, so we will simply add these. Then we find the total value of economic liabilities, and subtract it from the value of non-operating assets to achieve a Value for Non-Operating Assets and Debt.
To find the Market Value of Equity, we simply multiply the share price by the number of shares currently held by all its shareholders (shares outstanding)
We must first determine the current value of free cash flows, using the Weighted Average Cost of Capital.
Weighted Average Cost of Capital can be found by inferring the cost of each kind of capital source, which more often than not is a form of debt or equity.Equity’s cost of capital is mainly down to the opportunity cost held by the investor, as the investor could have had the opportunity to invest in another company with a similar risk profile. To determine the cost however we can use the CAPM model.
The cost of debt capital however is equivalent to the actual or imputed interest rate on the company’s debt, adjusted for the tax-deductibility of interest expenses, which can be determined using the following Debt Lite model.
Finally, we weigh the cost of each kind of capital by the proportion that each contributes to the entire capital structure. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business.
We then extend the Forecast Period as far as necessary to match the current stock price. Our residual value matches a projected inflation rate of 1.6%. This allows us to find how far ahead the market is priced in.
By: Aarav ManekTitle: The Expectations Investing FrameworkSourced From: streetfins.com/expectations-investing/Published Date: Tue, 26 Jul 2022 14:52:41 +0000