Lesson 6 of 7
Finding the variant view
State in three sentences what the price already assumes, what you believe differently, and why you might be right.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Today's price already assumes a growth rate and a set of margins, and solving for them comes before adding your own view.
- A variant view names the one or two inputs you believe differently, and by how much, not a general feeling that a stock is cheap.
- A variant view has to be falsifiable: state the evidence that would prove it wrong, not only the evidence that would prove it right.
A price is not a fact about a business. It is a claim about the future, and solving it backwards shows exactly what that claim requires before you add anything of your own.
What the price assumes against what the thesis assumes
Priced in
- 12 percent revenue growth, each of the next five years.
- Operating margin held at 18 percent.
The thesis
- 5 percent revenue growth.
- Operating margin widening to 22 percent as the product mix shifts.
The gap between the two rows, stated as numbers, is the variant view.
On revenue of 100, year five is 31.7 of operating profit in the price (100 x 1.12^5 x 18%) and 28.1 in the thesis (100 x 1.05^5 x 22%). The wider margin does not make up for the slower growth: the thesis expects about 11 percent less profit than the price already assumes.
Solve the model backwards first
A discounted cash flow model can be run in reverse: fix every input but one, and the current price implies a growth rate for the input left open. Read that way, rather than forecasting first and comparing to the price afterward, it states plainly what has to happen for today's price to be fair.
State the difference in one sentence
Marks calls this second-level thinking. The first level asks whether a company is good. The second asks what the price already assumes and states the difference: the price assumes one thing, you expect another, for a reason you can name. A difference with no stated reason is a preference, not a thesis.
Point at something specific
The reason has to name something the market can plausibly be missing (a change not yet visible in trailing figures, a strong segment blended into a weak total, a temporary problem read as permanent). Mauboussin and Rappaport's expectations investing works the same way: solve for what the price assumes, then test that assumption against the evidence.
The market being right is the other outcome
Most prices are not obviously wrong, and a variant view is a specific, testable difference of opinion, not a claim that the market is generally mistaken. The same figures that would prove the view right, next year's growth rate or margin, are the ones that would prove it wrong.
Check yourself
Why solve a valuation model backwards for the growth rate a price implies?
- Because forward earnings estimates are always more reliable than trailing ones
- Because it states exactly what has to happen for today's price to be fair, before any view is added
- Because it removes the need for a discount rate
Show the answer
Answer: B.
Working backward from the price separates what the market already assumes from what an investor is adding to it.A variant view is best stated as
- A general sense that a stock looks cheap
- A specific input you believe differs from the market's, and the reason why
- A forecast of next year's share price
Show the answer
Answer: B.
Naming the input, growth or margin, and the reason for the difference, is what makes a variant view testable at all.What makes a variant view falsifiable?
- Being confident enough to size the position heavily
- Naming the evidence that would prove it wrong, not only the evidence that would prove it right
- Waiting long enough for the price to move in your favor
Show the answer
Answer: B.
A view that only ever looks for confirming evidence is not falsifiable, whatever the underlying facts turn out to be.Sources
- Marks, The Most Important Thing, 2011: second-level thinking, and risk as something other than volatility.
- Mauboussin and Rappaport, Expectations Investing, 2001: solving for the expectations already built into a price.
What this leaves out
- The figure and the worked example are illustrative. No filed company's price or margin appears here.
- Solving a price backwards depends on every other assumption in the model. Change the discount rate or the terminal year and the implied growth rate changes too.
- A variant view being well reasoned does not make it right. The market can be correct and the investor wrong.
- Nothing here is advice about any security.