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Expectations Value – The Model

Expectations Investing

Value investors are in constant search of securities that appear cheap as compared to their fundamental or intrinsic value. Intrinsic value is the valuation of the underlying business.

Intrinsic value can be calculated using multiple methods, but at its crux, it is an attempt to calculate the present value of the (expected) future cash flows from a going concern (accounting term for a company that can continue to operate indefinitely). The sum of these cash flows discounted at an appropriate rate (cost of capital or the expected rate of return for both debt and equity holders) gives the intrinsic value for a security.

Intrinsic value calculation is dependent on investor’s ability to forecast cash flows way ahead in the future. As companies go thru business-cycles in the ever changing macro environments, ability to forecast cash flows accurately is nothing short of magic. Add the complexity of technology and political disruptions, this now looks like an impossible task to get right.

Then again, for a value investor, it is not the precision of this intrinsic value that matters, but a range that covers the realistic possibilities of the underlying assumptions. Market valuations when compared to this intrinsic valuations range determine the under/over valuation of the security. Margin of safety further reduces the risk in buying the undervalued securities.

Once the intrinsic value is calculated and a cheap, formidable business is found, the job then still not very easy: investors need buy and hold till the market agrees with the valuation and re-prices the security.

While there is no denying that this indeed is the right method to value a business, it ignores the “market” aspect of valuation.

Companies trading at high (>50) PE or high PB (>5) multiples continue to give excellent returns for years, like, Asian Paints, HDFC Bank, Eicher Motors. Gruh Finance trades at >10 PB multiple and still gives decent returns. Even after using the most optimistic growth assumptions the intrinsic valuations of these companies turn out to be much lower than the market valuations.

Why then would the market not only continue to value them richly but also in fact give returns much better than the overall market returns? “Expectations Value” is one way to explain this phenomenon. Market in its collective wisdom values a company on the expectations of its earnings growth for the current year. Meeting or exceeding these expectations result in the markets rewarding these securities.

This is similar to “appraisal” process in most IT companies. Every year a certain set of KRA/KPIs (key review areas and performance indicators) are designed to evaluate the performance of an individual. Individuals exceeding these expectations are rated higher and hence rewarded with higher salary growth, bonus and/or promotions.

Individual rewards are also influenced by the performance of the company/business-unit for the year. Better the company performance, better is the reward and vice-versa.

This is exactly how it happens in the stock market. Based on the company performance measured against its expectations, the stock is rewarded with price increase. Better the market (index) performance, typically, higher is this price increase.

How do we apply this in stock picking? What is the best time to define these expectations? How do we define them? More importantly, how do we validate the viability of these expectations for every company? What has been the historical performance of such a strategy? So many more questions to go and answers to be sought….this is just the beginning!!

1 thought on “Expectations Value – The Model”

  1. Very well described and explained in a language that is very easy to understand for a layman.

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