Expectations Investing by Michael J. Mauboussin

Author:Michael J. Mauboussin
Language: eng
Format: epub
Tags: BUS036060, Business & Economics/Investments & Securities/Stocks, BUS036070, Business & Economics/Investments & Securities/Analysis & Trading Strategies
Publisher: Columbia University Press
Published: 2021-09-28T00:00:00+00:00

8

Beyond Discounted Cash Flow

When you apply the expectations investing process, you will run across companies with price-implied expectations that appear more optimistic than what the existing businesses and industry norms would lead you to anticipate. It can be a mistake to automatically conclude that expectations are too optimistic in these cases. For companies filled with uncertainty, the stock price is the sum of discounted cash flow value, representing the existing businesses, plus real options value. Real options capture the value of uncertain growth opportunities. In this chapter, we show you how to use some straightforward real options valuation techniques to augment the power of expectations investing.1 We also introduce the notion of reflexivity, which explains how stock prices can affect business fundamentals.

The discounted cash flow model is all you need to estimate the expectations for most businesses. But many investors have come to question the model’s role in valuation because it does not easily explain why some start-ups, especially those that lose money, enjoy such large market capitalizations. We believe that the discounted cash flow model is as relevant as ever if you complement it with a real options analysis for select companies.

Real options analysis is critical for start-ups that are early in their life cycles and hence have limited operating track records. Most start-ups need to invest significant sums to build infrastructure, establish brand identity, and acquire customers. Few of these companies have meaningful revenues, and fewer yet are profitable.

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