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Book Review: Expectations Investing

Why don’t average investors use discounted cash flow analyses?  Typically, they don’t use them for several reasons.

  • Most people don’t want to use an algebraic formula to estimate anything.  As some legendary trader reputedly yelled at a quant, “No formulas!  You can make me add, subtract, multiply, and divide!…  And don’t make me to divide too often!”
  • It is not intuitive to most.  It takes a bond-like or actuarial approach to analyzing stocks — forecasting future free cash flows and discounting them at the firm’s cost of capital.
  • It is highly sensitive to assumptions one employs.  Small changes in growth rates or discount rates can make a big difference in the estimate of value.  It lends itself easily to garbage in, garbage out.  (I remember a Dilbert cartoon where an analyst told Dogbert that scientific decision analysis required forecasting future free cash flows and discounting them.  He added that the discount rate had to be right or the analysis would be garbage.  Dogbert’s comment was to the point: “Go away.”)
  • It takes a lot of work, and shortcuts are easier, providing most of the analysis with less effort.

Now, most professional investors don’t use DCF either, for many of the above reasons.  But there are a number that do, among them Buffett.  Morningstar uses DCF for its stock recommendations.  It’s not a bad system after one makes the effort as an organization to standardize your free cash flow estimates and discount rates.  Most professionals invert the process, and rather than trying estimate what a stock is worth, they estimate what they think the company will return at the current market price.

Expectations Investing is one way to formalize DCF, and a rather comprehensive one.  It would be a good way for an investment organization to formalize its investment process, but is way too complex for one person implement, unless one is following some type of simplifying system like Morningstar, ValuEngine or any of the other purveyors of DCF analyses out there.

In the process of formalizing DCF, the book explains the problems with traditional P/E analysis, and how a focus on free cash flow can remedy the problems.  A weak spot in the book is their discussion of cost of capital.  Their cost of equity capital analysis relies on beta, which is not a stable parameter, nor does it really capture what risk is.  That said, inverted DCF can work without discount rates.  The book takes the approach that the discount rates are the less critical factor, because when they change for one firm, they typically change for all firms.  The book’s solution is to use current prices to drive DCF backwards and determine market free cash flow expectations for a stock.

The analyst can then look at those expectations, and try to determine whether they are too high or too low.  The analyst can also look at whether there might be changes due to unit growth, product price changes, operating leverage, economies of scale, cost efficiencies, and changes in the marginal efficiency of capital.  After the analysis, usually one or two factors will stand out capturing a large portion of the variability.  The analyst then focuses on those, and what drives them.  Unexpected changes lead to revisions to the analyst’s model, and the game continues.

Beyond that, the analyst needs to understand how the company in question fits into its industry.  The book discusses Michael Porter’s five forces, the value chain, disruptive technologies, and the economics of information.  Beyond that, the book touches on:

  • Real Options — the ability of a company to pursue value enhancing projects or not.
  • Buybacks — do them when the company has no better opportunity, and the shares are undervalued.
  • Mergers and Acquisitions — how to tell when are they good or bad ideas.
  • Reflexivity — Are there situations where a higher or lower stock price affects the business?  High/low valuation makes financing easy/difficult.
  • Understanding management incentives — how will they affect financial results and management behavior over the short and long runs.

At 195 pages in the body of the book, Expectations Investing is not a long book for what it covers.  The flip side of that is that is breezes over much of the complexity inherent in what they propose.  One other shortcoming is that little time is spent on financials, which are a large part of the market, and for which it is intensely difficult to calculate free cash flow.  After reading the book, I would have no idea on how to apply their DCF model to valuing a bank or an insurance company.

Aside from financials, if someone were to ask me, “Is this how valuation should be done?” I would say, yes, ideally so.  But it brings up one more critique: though I hinted at it above, most of the shortcuts that investors use are special adaptations and first approximations of the DCF model.  That is why shortcuts have validity — if you know the critical factors that drive profitability for a given company or industry, why waste your time on a big model with many inputs?  Cut to the chase, and use simpler models industry by industry.

Who would benefit from this book: someone who either wants a detailed means of calculating a DCF model, or a taste of the issues that an analyst/investor has to consider as he evaluates the worth of a company’s stock.

This is a neutral review from me.  I neither encourage or discourage the purchase of the book.  It has its good and bad points.  But if you want to purchase it, you can find it here: Expectations Investing: Reading Stock Prices for Better Returns.  I have a copy of Damodaran’s The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses (2nd Edition), weighing in at 575 pages, as well as his book Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Second Edition (similar size, with a quarter inch of dust on my shelf.  Guess I don’t use it that much).

I could do a review of one or both of those, but if Expectations Investing is overkill for the average investor, and light for the professional, then either of Damodaran’s books are for the professional only.  At best I think it would only produce a review on the weaknesses of DCF analysis.

Full disclosure: If you enter Amazon through my site, if you buy something there, I get a small commission.  Your price does not change.  I review old and new books, and I don’t like them all; my goal is to direct readers to the books that can best help them.

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22 Responses to Book Review: Expectations Investing

  1. pwm says:

    Thank you. That is helpful.

    I’m starting in on my CFA curriculum. Would this book be good to read in advance, or will the curriculum cover what is in the book?

  2. The CFA curriculum should cover the material at a level between that of Expectations Investing and Damodaran. Your choice. I would read the Syllabus, because the terminology might differ a little.

  3. OT David, but last month you asked if anyone had any stock ideas for you or your readers. I mentioned three names. As of today, they are up 26%, 390%, and 60%, respectively.

  4. Nick says:

    Another intelligently considered book review, thanks David!
    For readers outside the US (I’m in the UK), is there a suffix we can add to the local Amazon url to achieve the same commission effect for you on our purchases?

  5. matt says:

    DCF is a very hard thing to do because it is so sensitive to your inputs, especially growth and the marginal cost of capital. I haven’t seen anyone who can reliably predict both. In my opinion, there needs to be very egregious mispricing in order for DCF to flesh out bargains.

  6. Fu says:

    Sorry to be off-topic, but the biggest story not being told is that the Federal Reserve has no authority to buy Fannie Mae and Freddie Mac mortgage backed securities (MBS).

    The Federal Reserve on their website claim they have authority under section 14(b) of the Federal Reserve Act, but from my reading of the law, none of the clauses in that section seem applicable. Fannie Mae and Freddie Mac MBS is *not* backed by the full faith-and-credit of the US government, and thus should not be eligible for purchase by the Federal Reserve.

    Despite Fannie and Freddie’s conservatorship status, they are still government sponsored enterprises and not U.S. government agencies. One can verify that their MBS is not backed by the full faith-and-credit of the US government through several sources (and not that foreign central banks has essentially stopped buying it). In fact the prosepctus for the MBS that Fannie and Freddie are issuing *right now* still has a disclaimer that the securities are not backed by the full faith-and-credit of the US government.

    If the Federal Reserve has no authority to buy Fannie Mae and Freddie Mac mortgage backed securities as seems to be the case, they are making such purchases illegally, and are thus spending over 1 trillion dollars of tax payer money illegally.

  7. Nick: the only thing that uniquely identifies me is this code: &tag=thalbl-20

    Thanks for thinking of me.

  8. Fu — When the US nationalized Fannie and Freddie, they guaranteed the senior and junior bond obligations of both.

    Foreign investors don’t trust the guarantee, but the guarantee is there just the same. Fannie & Freddie’s MBS are senior obligations of F&F because they guarantee the creditworthiness at the senior level of their balance sheet. Thus, the US taxpayer has guaranteed those as well.

    Sad but true. Made decent money for clients off of the debt guarantee — long senior noncallables were the place to be.

  9. TDL says:

    This review leads to a question I’ve been meaning to ask you. If you don’t use beta, what do you use to estimate the cost of capital? I’ve only been exposed to DCF from the banker point of view (and they seem to always use beta.)


  10. Fu says:

    Hi David,

    > When the US nationalized Fannie and Freddie,
    > they guaranteed the senior and junior bond
    > obligations of both.

    Where is the announcement? I can’t find any evidence that you are correct.

    Look at the prospectus for current issues of Fannie and Freddie MBS… Legally it is not backed by the full faith-and-credit of the U.S. government. And legally is what matters in terms of following the law. This is a nation of laws.

    There is no guarantee.. that’s why foreign investors don’t trust it.

    Of course Congress could change the law, but that’s no excuse for the Fed breaking the law as it stands now.

  11. F&F guarantee all the MBS they issue. These are senior obligations of F&F. This is not disputable; it is where the MBS guarantees stand in the bankruptcy code.

    As Fitch commented at the time: The subordinated debt ratings are affirmed based on the support vrepresented by the Senior Preferred Stock Purchase Agreements (Agreements) between the U.S. Treasury and the companies. The Agreements protect both senior and subordinated debtholders from potential losses from operating the GSEs as any deficiency between assets and liabilities will be made whole up to $100 billion as provided.

    That is a significant guarantee. Could it be burned through? Sure, but sadly, the losses would have to burn through the preferred in entirety, and that is most of the bailout. Hard for the preferred to go out at zero. Easy for it not to go out at par.

  12. Anonymous says:

    David, the one problem with Expectations investing and other “proprietary” DCF methods like CFROI, EVA, etc. that you didn’t mention is that if the market is not using the same technique it doesn’t really give the user an accurate representation of whether the stock is over/undervalued. Since all of these methods require certian adjustments, and the adjustments can affect the value, if the market is not making the same adjustments it is not an apples to apples comparison. This also applies to reverse engineering the implied discount rate.

    This is why, despite the many flaws of multiples, it is easier to talk about what they imply with regard to the market — there’s more common ground for discussion. Also, changes in multiples do approximate changes in return on capital.

  13. Anon — points well made.

  14. tom brakke says:

    Thoughtful as always.

    This reminded me of a due diligence visit at a research firm. In a one-on-one with an analyst, I asked him about his valuation methods, and he said that he relied on multiples.

    Noting his resume, I asked, “Didn’t they teach you DCF at (major university)?”

    He said they did, but that he didn’t like it because there were “too many assumptions.”

    The nice thing about doing a DCF is that if it’s done well you force yourself to lay your assumptions out. It’s also easier to use probabilities if you want. Multiples are very useful, but too many assumptions get buried; real rigor comes from taking the next step.

    In all cases, whatever the method, the most important thing is to remember that there are no “answers” to be had; the exploration and consideration are the keys to insight.

    Which is why, by the way, you are the best investment blogger around. You explore and consider and let us in on your thoughts.

  15. Kieran says:

    As I recall, the primary example of DCF that this book uses is Gateway. Not sure exactly when this book came out, but it was around 2000. The point was to show how using DCF analysis could provide you with a reasonable range of the potential values a stock might have down the road. In so doing, the DCF analysis provided a positive and a negative expectation of Gateway earnings going forward over a seven year time horizon. I don’t recall exactly what the resulting expectations were, but even the pessimistic view was well above Gateway’s actual earnings. The reason? Dell undercut Gateway’s business model and essentially put them out of business. The lesson? DCF is only good if you a) have a firm understanding of a company’s business that relevant market and b) can reasonably predict multiple years down the road how that will develop. With technology, that’s hard to do. Yahoo’s 1997 DCF analysis couldn’t have predicted the development of Google. Similarly, what does Google’s DCF fail to contemplate? Hard to say, but my point is only to say that DCF must contemplate a large margin of safety, because many of these expectations can go wrong.

  16. Kieran — another good point. I was going to mention that, but I felt it would fall into the “cheap shot” category, because they were careful not to sound too bullish on it. Personally, I would have found that to be a difficult name to do DCF on. Not a stable business.

  17. Actually, USEG was up another 65% today, so the three stocks I mentioned here on 9/4 are now up… ah, what does it matter. You’re not going to respond to this comment anyway.

  18. Steven Milos says:

    Hi David,

    I’m not a fan of DCF either; I prefer to try and estimate a free-cash flow yield. With respect to Kieran’s points that you addressed: DCF works best with a stable business model. Otherwise, the cash flow input is very difficult to estimate accurately. Or, you end up with a very high discount rate to compensate for the unpredictability of the model. In any case, I’m not a fan. Thoughtful post though, thanks.

    As a separate topic, what’s your view of the Treasury market now? Yield curve slope? Recent increase in TIPS yield? I’m very interested to see what happens as the Fed steps away from the market; the November refunding should be very, very interesting. I enjoy reading John Jansen, but I know you’ll have an informed opinion, as an ex-bond man…

    long TBT

  19. Dave in H, sorry, I’m going to respond. Good for you. I play in larger companies; I have to because I want to run institutional money. I can’t play in stocks smaller than $100 million, which I believe all of those were when you first mentioned them. So, with full respect, way to go!

    Steve, I think once the Fed steps away, yields will rise a little, and if they dare liquidate, they will rise a lot. I am not constructive on any of the US bond market at present. I prefer shorter to longer, less volatility to more, less credit risk, and more currency risk. I particularly like currencies that have and/or might tighten policy, such as Australia, and uh, hmmm… maybe Brazil, but I can’t find that in a retail form.

    But aside from foreign currencies, I am flying the Jolly Roger here, and saying that yield = poison. This is a time to preserve capital, not make great gains.

  20. SamB says:

    I actually kept that Dilbert cartoon. If you want a copy, drop me a line and I’ll e-mail it to you.


  21. “I can’t play in stocks smaller than $100 million, which I believe all of those were when you first mentioned them. So, with full respect, way to go!”

    Thanks, David. As I wrote when I first mentioned those stocks here on 9/4, they would probably be too small for you but perhaps not for some of your readers. IMO, going small is an advantage that too few individual investors take advantage of.

  22. Steven Milos says:


    As a retail investor, if you wanted to play Brazil in currency form, you could try something like long EWZ, and then short an ETF like Australia (or a basket of ETFs), which should have a high correlation with EWZ to remove the equity market risk. You could then go long the Aussie dollar ETF to hedge your implied short A$ risk. A bit of a hassle, but I think you’d end up with a reasonable approximation for the real.

    I agree with your view on the bond market, hence my short position.

    long TBT


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

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