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How to make money picking stocks

Wednesday, May 19th, 2010

Material changes in the present value of expected cash flows are the key driver of material changes in a stock price. Accordingly, determining the investment merit of a given stock boils down to identifying gaps between the investor’s expectations for future financial performance and the market’s expectations.

Ergo: The best long-term strategy for making money in the stock market is: “Buy low expectations and sell high expectations.”

Sounds easy…but it is not easy…or everyone would do it, right?

There are two key challenges to executing this strategy:

1. Measure the true profitability of the business. Details on how we do that are here: translating accounting data into economic earnings.

2. Measure the future cash flow expectations embedded in the stock price. Details on our how we do that are in Figure 1 below, which shows the table in every one of our models used to display the expectations embedded in the current stock price.

Our models focus on quantifying the expectations for future cash flows embedded in the market price or any target price.

Clients can also analyze expectations using multiple forecast scenarios. All of our models are pre-populated with forecasts based on consensus estimates wherever possible.

Using the info from the Decision Page in Company Models:

Figure 1 provides investors with the information needed to make informed decisions about a company’s valuation. With this information, investors can determine whether or not they:

  1. Agree with market expectations and believe a stock is properly valued
  2. Believe market expectations are too high and a stock is overvalued
  3. Believe market expectations are too low and a stock is undervalued

Figure 1 – The Valuation Matrix

Figure 1

Source: New Constructs, LLC

Understanding the expectations for future cash flows embedded in stock prices is not possible with accounting data or any ratios (e.g. P/E, EBITDA, etc) based on accounting data. You need a dynamic discounted cash flow model to measure the expectations embedded in stock prices.

Leveraging our patented research platform, we build and update thousands of economic earnings and discounted cash flow models daily, which is why we have confidence in our stock picks.

For more details on how we find stocks with “low expectations” as well as super-high expectations, see Investment Strategy 101.

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  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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