Lesson 1 of 9
What the price already assumes
Instead of forecasting and comparing with the price, solve the model backwards for the growth the price already implies, then judge whether that is likely.
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
- Forecasting a company and comparing the result with its price is unbounded. Solving the same model backwards for what the price implies is bounded, and answerable.
- Two variables, growth and margin, can each reproduce the same price. The honest output is a frontier of pairs, not one number.
- The result is a sentence to argue with using what you know about the industry, not a value and not a recommendation.
Forecasting a company and comparing the result with its price asks you to guess at everything. Solving the same model backwards, for what the price already assumes, asks only whether that assumption is plausible. Rappaport and Mauboussin call this reversal expectations investing.
Pairs of growth and margin that reproduce the same $1,500 price
- Growth needed to reproduce the price
Show the numbers
| Growth needed to reproduce the price | |
|---|---|
| Margin 12.5% | 14.5% |
| Margin 13% | 12.9% |
| Margin 13.5% | 11.4% |
| Margin 14% | 10.0% |
| Margin 14.8% | 8.0% |
The no-growth anchor comes first
Before solving anything, find what the business is worth with no growth at all: operating profit after tax divided by the cost of capital. Subtract that from the quoted enterprise value, and the remainder is what the market is paying for growth that has not happened yet, stated in currency rather than in adjectives.
The solve
Fix everything except two variables and solve for what is left. Take the price as given, the discount rate as given, and the historical capital intensity as given; hold operating margin at its filed level and solve for the growth rate that reproduces the quoted price.
Growth or margin, and why the answer is a frontier
The two free variables are not separately identified. Many pairs of growth and margin reproduce the same price, so the model's honest output is a range rather than a point.
| Growth 14.5%, margin 12.5% | Growth 8%, margin 12.5% | Growth 8%, margin 14.8% | |
|---|---|---|---|
| Enterprise value the model returns | 1,500.7 | 1,245.2 | 1,500.6 |
At half the growth and the filed margin, the model returns 1,245.2 against a quoted 1,500, a shortfall of 17 percent. At 8 percent growth the price only reproduces if margin reaches 14.8 percent. Choosing which variable to hold fixed is the analyst's judgement, not a property of the model.
The habit behind the arithmetic
Marks's second-level thinking, in The Most Important Thing, is this exercise as a habit rather than as arithmetic: first-level thinking asks whether a company is good, second-level thinking asks what the price already assumes about it. A reader who forms the habit gets most of the benefit even without running the numbers; a reader who runs the numbers without the habit forgets why they did it.
Check yourself
What does solving a valuation model backwards, for the implied growth rate, actually produce?
- The company's intrinsic value
- A description of what the current price assumes about the future
- A forecast of next year's earnings
Show the answer
Answer: B.
The exercise takes the price as given and solves for the operating performance that would justify it. That is a statement about the price, not a value or a forecast.Two variables, growth and margin, are both left free in the model. Why is the result a frontier rather than one answer?
- Because the model is broken
- Because many different pairs of growth and margin can reproduce the same price
- Because growth and margin are always equal
Show the answer
Answer: B.
With two variables unfixed, more than one combination solves the equation. Which one to report is a judgement about which variable is more reliably estimated, not something the arithmetic decides.Why does the no-growth anchor come before solving for implied growth?
- It does not matter when it is computed
- It isolates how much of the price is paying for growth that has not happened, in currency rather than adjectives
- It replaces the need to solve for growth at all
Show the answer
Answer: B.
Subtracting the no-growth value from the quoted price turns "the market expects a lot of growth" into a specific amount of money, which is the more falsifiable claim.Sources
- Rappaport and Mauboussin, Expectations Investing, 2001, on solving for the expectations already embedded in a price.
- Marks, The Most Important Thing, 2011, on second-level thinking as the habit this exercise makes explicit.
What this leaves out
- The implied figure is conditional on every input held fixed: the discount rate, the horizon and the terminal structure. State them beside any implied rate, or the rate means nothing.
- Capital intensity is assumed to hold at its historical level, which is the assumption most likely to be wrong and the one least often checked.
- The worked examples use round invented numbers. Every price in ValueScreener is stored, not live, so this exercise is run with a price the reader fetches themselves.
- Nothing here is advice about any security.