Investors Should Look Harder At Expectations

Investors Should Look Harder At Expectations

An opinion piece in the Financial Times argues that investors should incorporate expectations into their investing decisions more rigorously. Studies have shown that price and value can converge quickly even when an investor only has partial information—but those same studies also demonstrate that price and value can diverge extensively when investors become overly optimistic or pessimistic.

Many investors find analytical models that value future cash flows too speculative, and rely instead on shorthands such as applying multiples of price to earnings. This might save time, but multiples lack clarity by conflating drivers of corporate value like profit margins, investment needs, and sales growth.

Instead, taking an “expectations investing” approach may help overcome the disadvantages of a model that uses multiples. The strategy has 3 steps, outlined in the article:

  • Reading price-implied expectations. An open-minded investor can do well if they start with price to then discern the market’s expectations for a company’s value drivers.
  • Apply strategic and financial analysis to determine if expectations are too high, too low, or just right. The point here is to determine which driver of value is most important, in order to develop scenarios of probable outcomes.
  • Lastly, compare the expected value to the stock price in order to make an informed decision to sell or buy.

This approach provides a measured, thoughtful way to make investment decisions.