expectations investing expectations investing reading stock prices for better returns ALFRED RAPPAPORT MICHAEL J. MAUBOUSSIN HARVARD BUSINESS SCHOOL PRESS BOSTON, MASSACHUSETTS Copyright 2001 Alfred Rappaport and Michael J. Mauboussin All rights reserved Printed in the United States of America 05 04 03 02 01 5 4 3 2 1 SVAR® and SSVA® are registered trademarks of L.E.K. Consulting LLC. Requests for permission to use or reproduce material from this book should be directed to
[email protected], or mailed to Permissions, Harvard Business School Publishing, 60 Harvard Way, Boston, Massachusetts 02163. Library of Congress Cataloging-in-Publication Data Rappaport, Alfred. Expectations investing : reading stock prices for better returns / Alfred Rappaport, Michael J. Mauboussin. p. cm. Includes bibliographical references and index. ISBN 1-57851-252-2 (alk. paper) 1. Investment analysis. 2. Portfolio management. 3. Stocks—Prices. I. Mauboussin, Michael J., 1964– II. Title. HG4529 .R37 2000 332.63'2042—dc21 2001024378 The paper used in this publication meets the requirements of the American National Standard for Permanence of Paper for Publications and Documents in Libraries and Archives Z39.48-1992. To Sharon To Michelle contents Greater Expectations: How Investing Differs from Art Collecting by Peter L. Bernstein Preface Acknowledgments 1 The Case for Expectations Investing Active Management: Challenge and Opportunity The Expectations Investing Process The Twilight of Traditional Analysis Essential Ideas Appendix: Earnings Growth and Value Creation Part I Gathering the Tools 2 How the Market Values Stocks The Right Expectations Shareholder-Value Road Map Free Cash Flow Cost of Capital Forecast Period From Corporate Value to Shareholder Value Summary Illustration Essential Ideas Appendix: Estimating Residual Value The Perpetuity Method The Perpetuity-with-Inflation Method 3 The Expectations Infrastructure The Expectations Infrastructure Not All Expectations Revisions Are Equal Essential Ideas 4 Analyzing Competitive Strategy The Dual Uses of Competitive Strategy Analysis Historical Analysis Competitive Strategy Frameworks Essential Ideas Part II Implementing the Process 5 How to Estimate Price-Implied Expectations Reading Expectations Gateway Case Study Why Revisit Expectations? Essential Ideas Appendix: Employee Stock Options and Expectations Investing Valuing ESOs 6 Identifying Expectations Opportunities Searching for Expectations Opportunities Pitfalls to Avoid Gateway Case Study Essential Ideas 7 Buy, Sell, or Hold? Expected-Value Analysis Gateway Case Study The Buy Decision The Sell Decision The Role of Taxes Essential Ideas 8 Beyond Discounted Cash Flow Real Options When to Use Real-Options Analysis in Expectations Investing The Value of Real Options in Amazon.com Reflexivity Essential Ideas 9 Across the Economic Landscape Business Categories Business Categories and the Value Factors Essential Ideas Part III Reading Corporate Signals 10 Mergers and Acquisitions How Acquiring Companies Add Value Evaluating Synergies What to Do When a Deal Is Announced Essential Ideas 11 Share Buybacks The Golden Rule of Share Buybacks Four Popular Motivations for Share Buybacks Essential Ideas 12 Incentive Compensation CEO and Other Corporate-Level Executives Operating-Unit Executives Middle Managers and Frontline Employees Essential Ideas Notes Index About the Authors greater expectations how investing differs from art collecting Peter L. Bernstein How does the capitalist system really work? In Capital, Karl Marx uses a remarkably simple equation to answer this question: