Expectations Investing: Reading Stock Prices for Better Returns, Revised and Updated

Heilbrunn Center for Graham & Dodd Investing Series

by Michael J. Mauboussin, Alfred Rappaport

Most investment books try to assess the attractiveness of a stock price by estimating the value of the company. Expectations Investing provides a powerful and insightful alternative to identifying gaps between price and value.

Michael J. Mauboussin and Alfred Rappaport suggest that an investor start with a known quantity, the stock price, and ask what it implies for future financial results. After showing how to read expectations, Mauboussin and Rappaport provide a guide to rigorous strategic and financial analysis to help investors assess the likelihood of revisions to these expectations. Their framework traces value creation from the triggers that shape a company's performance to the impact on the value drivers. This allows a practitioner of expectations investing to determine whether a stock is an attractive buy or sell candidate.

Investors who read this book will be able to evaluate stocks of companies in any sector or geography more effectively than those who use the standard approaches of most investors. Managers can use the book's principles to devise, adjust, and communicate their company's strategy in light of shareholder expectations.

This revised and updated edition reflects the many changes in accounting and the business landscape since the book was first published and provides a wealth of new examples and case studies.

Genres: Finance, Business, Economics, Nonfiction, Money

272 pages, Hardcover

Published September 28, 2021

About the author

Michael J. Mauboussin is Chief Investment Strategist at Legg Mason Capital Management. Prior to joining LMCM in 2004, Michael was a Managing Director and Chief U.S. Investment Strategist at Credit Suisse. Michael joined CS in 1992 as a packaged food industry analyst. He is a former president of the Consumer Analyst Group of New York and was repeatedly named to Institutional Investors All-America Research Team and The Wall Street Journal All-Star survey in the food industry group.

Michael is the author of Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional PlacesUpdated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of The 100 Best Business Books of All Time by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

Michael has been an adjunct professor of finance at Columbia Business School since 1993 and is on the faculty of the Heilbrunn Center for Graham and Dodd Investing. In 2009, Michael received the Deans Award for Teaching Excellence. BusinessWeeks Guide to the Best Business Schools (2001) highlighted Michael as one of the schools Outstanding Faculty, a distinction received by only seven professors.

Michael earned an A.B. from Georgetown University. He is also affiliated with the Santa Fe Institute, a leading center for multi-disciplinary research in complex systems theory, and is on the board of directors of Sermo, an online community for physicians."

Reviews

[Rishabh Srivastava · Rating 5 out of 5]

This was an excellent bridge between valuations driven by a DCF model (like those Damodaran wrote about in Narrative and Numbers), and those of startups that are priced, essentially, as options

Great read if you’re trying to acquire an additional framework for valuing securities — especially those of currently unprofitable, high-growth companies

[Liew · Rating 4 out of 5]

Central idea author argues is that stock moves when there is delta between actual and expects results i.e. when actual > expected, stock moves positively, vice versa. Some nuances covered / methodologies shared as well - those are nice tools to have for an investor.

This is especially true for investing in tech / SaaS stocks, where businesses / stocks are often priced for perfection. In these cases, expectations built in become crucial i.e. if market is expecting 45% + positive guidance and company comes out with 40% YoY, these stocks will surely be punished by the market (e.g. $FRSH, $ADBE - both of which got punished for "missing" expectations. Many more, in both large-mid-small caps). Hence, using those tools described / shared can come in handy though I think consensus numbers & reverse DCF are often good enough for a quick sense.

For seasoned investors, I would say it is worth a quick browse!

[Trevor Tsui · Rating 3 out of 5]

If you’re relatively new to investing, this would be a useful read. It provides a good summary of various helpful / widely used mental frameworks. Otherwise, if you aren’t new to investing and read investing literature more broadly (incl. blogs, fund manager reports etc.) there are very little insights contained in this book.

[Sanford Chee · Rating 4 out of 5]

“Invert, always invert.” -Charlie Munger
Interview on TIP:
https://podcasts.apple.com/sg/podcast...

Moderated by Saurabh Madaan
https://podcasts.apple.com/sg/podcast...

Expectations investing website (module 8 Domino’s Pizza template)
https://www.expectationsinvesting.com/

https://www.expectationsinvesting.com...

The 1 job as an investor: understand the unit economics of the biz (per store/per customer acquired etc); competitive moat

Expectations implied about:
Growth
Margins
Reinvestment rate
Capital intensity
ROIC = S/A x EBIT/S x NOPAT/EBIT where A = PPE + net working capital
Cost of capital
EVA = (ROIC - WACC)*IC

Base rates for assumptions/expectations

Margin of safety

“‘Crist on Value’ is the best 13 pg written on investing.” -Michael Mauboussin
https://www.hvst.com/posts/value-and-...

Apply Charlie Munger’s Laticework of Mental Models - rf to Shane Parrish’s book on the subject.

[Matthew Gaines · Rating 5 out of 5]

Very good framework for figuring out what expectations are in a stock.

Definitely going to require a second read but I felt this very simply broke down the drivers of value

[Fernando Iberico · Rating 4 out of 5]

Expectations Investing

Uno de los referentes en inversiones a nivel global es Michael Mauboussin. Sus papers y libros constituyen una excelente fuente de conocimiento para entender el mundo actual de las finanzas. Su último texto - Expectations Investing (2021) - es un manual breve, práctico y orientado a profesionales que desean sumergirse en el proceso de valorización de empresas.

Este libro contiene tres ideas medulares: i) invertir se apoya principalmente en las expectativas; ii) dichas expectativas gatillan cambios en el precio de las acciones; y iii) el trabajo clave de un inversionista es anticipar la revisión de las expectativas mencionadas.

De acuerdo con el autor, la valorización de una compañía debería empezar con la estimación de las expectativas implícitas que se desprenden de las cotizaciones del mercado. Esta práctica difiere del enfoque tradicional de proyectar los flujos de caja descontados como primer paso. De esta manera, invertimos el orden del proceso con el fin de conocer los supuestos más relevantes que sustentan el precio observado.

Tres apuntes que extraje de mi lectura:

1. El estrecho vínculo entre el análisis de ventaja competitiva y el proceso de valorización. Es imposible desvincular ambos conceptos. Es más, entender la industria, el modelo de negocio y la interacción con el entorno incrementan las posibilidades de prever dichos cambios antes de que se vean reflejados en los precios de mercado.

2. La utilidad de usar el modelo de “infraestructura de expectativas” que propone el libro. Con múltiples ejemplos y casos reales, el autor brinda una guía (paso a paso) para implementar dicho marco. Desde las fuerzas económicas básicas que dan forma al desempeño de una empresa (ingresos, costos e inversiones) hasta el proceso de toma de decisiones para comprar, mantener o vender una acción (reglas y recomendaciones).

3. La opcionalidad y las consecuencias de su incorporación en la valorización de empresas. El capítulo de opciones reales y el caso de Shopify constituyen, en mi opinión, la mejor introducción que he encontrado a la fecha sobre la importancia de no dejar este tópico de lado; sobre todo en el estudio de empresas tecnológicas o compañías con un alto componente de capital intangible.

[Etienne · Rating 5 out of 5]

Cannot recommend highly enough

Mauboussin etc continue to be required reading for any serious investor. A useful, clear and rigorous framework for assessing expectations, and even more helpful given the revisions from the previous edition.

[Ali · Rating 5 out of 5]

The best book on valuation out there. Mauboussin covers everything from how to use a DCF model to evaluate the expectations that are embedded in a company’s stock price to how to evaluate M&A deals. Feels like an MBA class textbook and is a must-read.

[Olivier Dardant · Rating 3 out of 5]

I was disappointed by the book. It all felt incredibly theoretical, we never got to the hands on part of the analysis. Using the stock price today to estimate imbedded expectations sounds fantastic, but I really don’t know how to do that based on this book.

[Isaac Chan · Rating 4 out of 5]

Isn't computing price-implied growth, or other fundamentals, a fundamental (pun not intended) tenet of finance and securities research already? It's literally one of the easiest things a finance student can do with a laptop and a set of assumptions. I don't know why they paint it as some game-changer that they invented lol, and even my boy Aswath himself fans the hype in his foreword. Maybe since Maubossin first wrote this in 2001, and people deadass didn't know how to back out implied fundamentals from prices back then in 2001. But that's so wild lol. Now, it's already so engrained in the finance curriculum.

Maubossin loves, especially in the 1st section of the book, to spit shit that's already prevalent in the literature, but give nice twists and use weird terminology (e.g., 'continuing value' instead of 'terminal value', 'corporate value' instead of 'firm value' etc). Made me think about what he's saying to just realize that I know this shit already and it's already in the literature lol. Modelled out all his case studies without guidance and could reproduce his results, which was a sick experience.

Maubossin skirts over and sort of slightly forces his case for expectations investing tbh. He insists that the market prices in a DCF of securities value, which I'm not entirely sure on, and I can honestly say no one can be sure on. His argument is flimsy and forced - he LITERALLY says that 'just because bond and CRE markets price value with DCFs, THEN we can expect equity markets to be as well'. Then he bases his entire framework on reverse-engineering DCFs of stock prices to find PIE. Maybe he, too, realized that his entire framework hinges on that one singular assumption - that (stock) markets sets prices with a DCF model - so he plays it off by hurriedly skirting over the building blocks of that claim lol. Homie thought I wouldn't notice.

Other than that, Maubossin displays his classic nerdiness and elegance in this book, showing off countless smart af calculations and giving me so many smart tools that although I could tell his ideas are leading somewhere profound, my tired brain can't fully comprehend the economic rationale behind why things work a certain way lol. Like how come it's the relationship between earnings yield and after-tax interest rate that dictate buybacks' impact on EPS.

Was also neat to sniff references to his ideas written in this book, in his podcasts and lectures. Made me think - even the greats just use and reference the same broad ideas over and over again in their careers

[Pedro Ceneme · Rating 5 out of 5]

Investing books start sounding very repetitive after you read a dozen of them. They rely on the same set of arguments while providing different examples to argument in favor of that, frequently oversimplifying the complexity and uncertainty regarding being a successful investor. Not rarely they are unusually verbose as well. This book, however, not only successfully summarizes all key frameworks to think about investing but admits readily to the uncertainty that plagues such process, while being very concise. It’s the best single source for anyone trying to get a coherent way of thinking about investing. I cannot recommend this book enough, either for seasoned professionals or interested “amateurs”

The central argument, which Mr. Mauboussin insists on remaining very grounded to, is that what determines how much a business is worth is its capacity of generating returns for every dollar invested, preferably while growing, above its cost of capital. If you invest in public securities, there is another layer of complexity here: how much expectation regarding the future path of profitability is embedded in the prices quote on stock exchanges. If you are an investor, you cannot generate returns by simply investing in a great business: you must buy it at a price that is coherent with the capacity of the business to generate such returns. More so, you should look for assets that where the price is indicating a substantially lower path of returns than what you believe the business can deliver. Such arguments are rather simple but is not rare for investors and writers to lose grasp of these simple premises. Always returning to such core tenants, the book shows a handful of frameworks on how to evaluate both the prospects of the assets to generate returns above cost of capital, how this can change in time (for better or worse) and, more importantly, how to assess how much of this is already priced by the market.

I’ve been following everything Mr. Mauboussin has written throughout the years and cannot summarize the dozens of insights he has managed to provide me. All that is contained in this book has been mentioned in one form or another in his many papers, but his ability alone to condense all in a handy “manual” of sorts deserves praise. His ability to discuss and frame all the complexity around investing in simple terms while not oversimplifying, however, is what sets this book in a whole other league.

[Green Investment Partners · Rating 4 out of 5]

Recommend adding this one to your reading list for a general investing understanding. It provides a slightly different perspective and makes the investment process more structured. We should always think about how we can improve.
https://www.amazon.co.uk/Ma-Maniere-D...

A few high-level points just for you to understand why it makes sense to read it:
1. Industry analysis (Porter five forces framework, what is the competitive advantage? How is the industry changing? Expectations? also recommend this for industry analysis
2. When analysing a business, we can solve for what is already included in the price. We can change this to how long is the market pricing this company for? For example 15% free cash flow yield can mean roughly only 6.6 years. On average the market is pricing companies from 5 to 15 years. Means you can have wrong expectations in the short term and long term. The market is a lot longer term thinking then we assume. For example, look at Google trading at 3% free cash flow yield
a. Various DCF models to back solve depending on industry and company types
3. Where can the expectations be wrong? Or where could the reversion of expectations occur? He calls them value factors. Not all expectations are equal.
a. Volume
b. Price and Mix
c. Operating Leverage
d. Economics of scale
e. Cost efficiency
f. Investment efficiency
4. Buy, Sell or Hold? Probability based (interesting to think about selling)
5. Real option value on top of DCF. For example R&D in process, or renewable pipeline etc, or option to expand etc. We have a lot of those. Interesting valuation model. Think about Shopify or Apple as a platform with lots of options.
6. M&A deals and analysis (good way of looking at synergies quite conservative)
7. Macroeconomic shocks how are we positioned?
8. Management: when mgmt. changes could be an interesting trigger point where the market gets expectations wrong?

What are situations where the market has negative expectations that are not justified? Short term earnings calls?

[Arun Kodumuru · Rating 4 out of 5]

Great book — highly recommend if you’re interested in basic underwriting strategy / drivers for a stock. The explanations of specific industries and how they relate to the drivers was extremely helpful. Specifically the discussion on service/knowledge companies and how they relate the scale was very helpful. Additionally, operating leverage is a very complex topic but it was explained here very clearly with the difference from Econ of scale outlines well. I also loved the case studies as simple examples for each concept. The section of business call options was also phenomenal — it’s a topic that’s never covered in finance but very important.

My only issue was at times the book fell short of really interesting topics that it would briefly touch on. Specially, when it came to operating leverage or investment efficiencies — the book never went into finding the fixed cost breakdown for companies or how to garner positive returns on investments. Also spinoffs and their value accretion was touched on for a line or two — it would’ve been great to dive into that. Calculations for M&A synergies would also be great. Overall i think the only caveat to the book is when it was getting into the weeds of a topic it err’d more on the theoretical side rather than directly applicable information (as explained above).

Then again I’m being very granular with my comments, and if you’re looking for a high level theoretical explanation of topics with some brief case studies — this is a great book for you!

[Firsh · Rating 5 out of 5]

I really liked this as I could trace back the developments from my investing newsletter I follow (and work at) to this. How they started asking the question what is priced into a given stock's price today, instead of "just" the usual fair value calculation. The book teaches the reader how to evaluate stocks based on the market's expectations, akin to reverse engineering "what would need to happen to justify the current price." I'm starting to like this Mauboussin character and I could tell that he is well-read and smart. The book brought up analyzing competitiveness, sort of mentioning the Innovator's Dilemma (that I've just read), ventured into the decision-making process that goes in buy/sell/hold, and beyond DCF. I especially liked a refreshing covering of how and when buybacks generate or destroy value, and all about M&A about which I haven't read much about yet. It was aslo interesting to hear that the market has a longer-term view than analysts dare to forecast, that's also partly why some stocks can be priced higher than what you'd calculate if you only looked at a few years in advance. Overall I feel like it definitely added to my knowledge, as it was part reaffirming that what my analysts are doing is great, part new stuff, and the stucture was well-put together from the ground up.

[Serhii Kushchenko · Rating 5 out of 5]

This book is pretty good. I will most likely re-read it. I am adding it to my list of recommended titles on stock trading and investing. Far from every book I read gets this honor.

I really liked the authors' ideas on how to calculate price-implied expectations. Also, I learned from this book how to use real options in addition to discounted cash flows model when valuing companies. I first learned about real options from Damodaran's book, but then I underestimated the importance of this idea.

Expectations Investing should not be your first book on fundamental analysis and valuation. Before proceeding with it, you would better gain some understanding of discounted cash flows. Otherwise, the book may seem abstruse and useless to you. The authors did not bother to explain the basics.

Before this book, you may want to read The Five Rules for Successful Stock Investing by Pat Dorsey. It is also desirable to gain some experience in studying the reports of companies.

Practice building simple discounted cash flow models in Excel. Save the files that you have created. As you read the book by Mauboussin and Rappaport, you will supplement your models with price-implied expectations calculations.

[Tab Williams · Rating 3 out of 5]

It is a fascinating framework that I think has a lot of utility, but Mauboussin/Rappaport do a horrible job of explaining it. I read it multiple times and still am unclear on how exactly to apply it. For instance, in the Dominos case is 8 years of expectations a lot or a little? Is the longevity of the expectations framework more important? The discount rate is such a dramatic mover in the model but very little ink is spilled on the topic. Many reasonable stocks (i.e. expectations of less than 10 years) turn into dramatically overvalued when putting in a HSD cost of capital. I am left with so many unanswered questions that effectively render the entire exercise almost useless. And frankly, this is infuriating because simply passing the book out to his class and asking for feedback would have solved a lot of the issues here, IMO.

There are a few chapters that you can just skip. They are either filler, summarization of other's work (competitive strategy) or academic restatements of conventional wisdom (buybacks)

[EPH320 · Rating 4 out of 5]

The book went over the core premise of investing in publicly traded equities - the key to generating excess returns is being able to (1) correctly identify market expectations embedded in a stock's price and then (2) properly analyzing those expectations and making a judgement call on whether those expectations are vindicated or not. The investor can bet on the magnitude of the expectations (10% as opposed to 5%) being different, or an entirely different direction (up vs. down and vice versa)

The useful part of this book would be in the middle chapters - which covers the framework on how to identify market expectations as implied by the stock price, how to properly analyze which expectations matter the most using a set of tools (competitive strategy, the expectations infrastructure, financial statement analysis etc.), and whether an investor should buy, sell, or hold a stock based on implied margin of safety and base rates.

[Liam Polkinghorne · Rating 3 out of 5]

Estimate the level of expected performance embedded in the current stock price and then assess the likelihood of a revision in expectations. Stock prices express the collective expectations of investors, and changes in those expectations determine investment success. Relies heavily on traditional financial theory (beta, equity risk premium etc). Found Chapter 4 the most useful chapter, summarising Mauboussin's approach to analysing competitive strategy.

[Kevin Johnson · Rating 4 out of 5]

Excellent book for buyside analysts looking for long and short ideas. It takes a simple concept that many investors know, and shows you how to actually quantify it. I really subscribe to the idea that, philosophically within a fund or research group, it is better to make our assumptions explicit and debate them publicly than to make them implicit and ignore them, and I believe this book does a good job of how to bridge that gap

[Jericka · Rating 5 out of 5]

Expectations Investing is a unique take on valuing stocks based on market expectations rather than just financial statements. My uncle Rick always thought a company’s past performance was the best predictor of success, but this book shows why understanding investor sentiment is just as important. Green investors who don’t pay attention to expectations can easily misjudge opportunities. It’s a great reminder that without the right perspective, even a promising investment can turn into a fraud.

[Arjun Pathy · Rating 5 out of 5]

By reversing traditional valuation methods, Mauboussin gets down to the core of how Mr. Market prices assets. Fundamental analysis is still the key; however, by first identifying expectations and then revising them based on original research, he presents a more effective means to pinpoint catalysts and under/overvaluation. Mauboussin's writing was enjoyable, with his emphasis on the aggregate market's long-term view and key metrics, such as ROIC spread, providing me with valuable context.

[Dimitri Tsoumpas · Rating 5 out of 5]

A sharp synopsis and expansion on the learnings of my MBA (with a specialization in finance)! This book offers a lot to consider and to think about in terms of integrating many facets. The material is presented in a way that assumes familiarity with the subject matter. Therefore, I’m not sure I would recommend this book to anyone who has not had formal education or training in finance.

[Nicholas · Rating 4 out of 5]

Having read a lot of his material (which comes up time and time again here) wasn't as new - but a book I wish I had read years ago. Not the easiest one to get through and quite dense on accounting principles

[Ferhat Culfaz · Rating 3 out of 5]

A detailed but heavy book. Requires a lot of time investment to undertake their analysis on specific companies. Perhaps maybe someone has done an excel template to analyse and make the recommendations?

[Tuan Nguyen · Rating 5 out of 5]

Must-read for every serious investor, executive, and manager. Provides crucial concepts on how to think about valuation, market pricing, and the true long-term drivers of shareholder value. Putting this on my re-read list.

[Pratik Kothari · Rating 3 out of 5]

The case study on Dominos is good and interesting on how to figure out what’s priced in and what can the triggers (one of the chapter). For the rest, can skip it all if one has read a few books on markets and businesses already.

[Joma Silva · Rating 4 out of 5]

Expectations Investing isn't your typical stock read. 🧠 Quite technical, it's for those passionate and deep into stock analysis.
It flips the script, showing the 'other side of the coin' beyond DCF, buybacks & M&A from an inverted perspective.
Intro from damodaran

[Abid Shivji · Rating 5 out of 5]

This was an informative read. Takes multiple investing concepts and combines them into a reverse DCF methodology to assess market expectations in a stock price.

[Anuraj Pandey · Rating 5 out of 5]

theoretical concepts
numerical data
re-read
hardcopy can be purchased- recommended for numerical and theorical understanding of concepts

[Heikki Keskiväli · Rating 3 out of 5]

Conceptually fresh and actionable ideas. For my taste, however, application was too theoretical.