The revolution — turn the DCF around
Chapter 1 of 13 · 10 min
Alfred Rappaport — creator of the modern DCF valuation of stocks — and Michael Mauboussin open Expectations Investing with an unexpected diagnosis: the problem is not that investors use the wrong model, but that they ask the wrong question. Instead of guessing the future and computing a value, we should read the market's baked-in expectations from the price and ask whether they are too low. This chapter explains the revolution and why it is a natural home in AKM1.
The classical path to a stock value begins in the future and ends in the present: the analyst forecasts revenue growth (V01), margins (V07, V08) and capital needs for five to ten years, discounts the cash flows and compares the result with today's price. Rappaport, who himself constructed this method for the stock market in the book Creating Shareholder Value and who was a professor at Kellogg, points out the paradox: the forecasts are the method's raw material and at the same time its weakest point.
Studies of analyst forecasts show systematic over-optimism — long-run growth forecasts almost always come in too high, and few companies grow for ten years at the pace the price guesses at. A traditional DCF thereby often becomes an expensive calculator giving one's own hopes a false precision.
Expectations Investing solves the problem by turning the computation around. The market price is not noise — it is the weighted midpoint of millions of actors' buying and selling, and therefore the most information-rich forecast there is. The question becomes not »what is the company worth according to my guesses?« but »what must be true — in growth, margins and capital return — for today's price to make sense?«.
Rappaport and Mauboussin call the answer price-implied expectations, PIE. The task of the analysis is then to judge whether these baked-in expectations are too low, reasonable or too high — a considerably lower and more often correct requirement on stock selection than hitting the mark oneself with one's own forecasts.
A worked example in plain text shows the difference in procedure. Traditional DCF: »I believe the company grows twelve percent per year for ten years, the margin rises to eight percent and capital needs are moderate — my value becomes 156 kronor, the stock costs 140, I buy.« Reverse DCF: »The stock costs 140 kronor. Which assumptions make that cost justified? Computing backwards, the price requires around nine percent annual growth for eight years, moderate margin improvement, and that the return on invested capital stays above the cost of capital the whole way.
Is that requirement lower than what I judge the company can deliver? If so, there is an expectations gap.« The same numbers — but the burden of proof has moved from my guesses to the market's requirements, and the market's requirements can be fact-checked.
For the AKM1 ecosystem this is a natural home. All AKM1 variables — revenue growth (V01), ARR growth (V02), gross margin (V07), EBITDA margin (V08), ROE (V09) — are precisely the valuation drivers a stock price bakes in. Expectations investing provides the method for emptying the price of its content and laying every V variable on the table for review. The concept of margin of safety (without a V number) becomes at the same time actionable: it is not a discount against a willful target price, but the distance between the market's baked-in requirements and a conservative assessment of reality.
If the price's requirements are low, the safety is large; if the price's requirements are high, there is no margin however fine the company.