Material changes in the present value of expected cash flows are the key driver of material changes in a stock price. Accordingly, determining the investment merit of a given stock boils down to identifying gaps between the investor’s expectations for future financial performance and the market’s expectations.
Ergo: The best long-term strategy for making money in the stock market is: “Buy low expectations and sell high expectations.”
Sounds easy…but it is not easy…or everyone would do it, right?
There are two key challenges to executing this strategy:
1. Measure the true profitability of the business. Details on how we do that are here: translating accounting data into economic earnings.
2. Measure the future cash flow expectations embedded in the stock price. Details on our how we do that are in Figure 1 below, which shows the table in every one of our models used to display the expectations embedded in the current stock price.
Our models focus on quantifying the expectations for future cash flows embedded in the market price or any target price.
Clients can also analyze expectations using multiple forecast scenarios. All of our models are pre-populated with forecasts based on consensus estimates wherever possible.
Using the info from the Decision Page in Company Models:
Figure 1 provides investors with the information needed to make informed decisions about a company’s valuation. With this information, investors can determine whether or not they:
- Agree with market expectations and believe a stock is properly valued
- Believe market expectations are too high and a stock is overvalued
- Believe market expectations are too low and a stock is undervalued
Figure 1 – The Valuation Matrix
Source: New Constructs, LLC
Understanding the expectations for future cash flows embedded in stock prices is not possible with accounting data or any ratios (e.g. P/E, EBITDA, etc) based on accounting data. You need a dynamic discounted cash flow model to measure the expectations embedded in stock prices.
Leveraging our patented research platform, we build and update thousands of economic earnings and discounted cash flow models daily, which is why we have confidence in our stock picks.
For more details on how we find stocks with “low expectations” as well as super-high expectations, see Investment Strategy 101.