What Your Stock Price Really Means

by Michael J. Mauboussin

There is a fascinating relationship between executives and the stock prices of the companies they manage. On the one hand, executives generally want their stocks to rise, affirming the perceived health of the enterprise they run and padding their remuneration. On the other hand, they frequently find their stock price inscrutable. The vast majority of executives think that their price is too low, but few can articulate an analytical case that backs that intuition.
Alfred Rappaport's article, "Stock Market Signals to Managers," in the November-December 1987 issue of the Harvard Business Review, provides managers with a clear method for understanding how price reflects the market's expectations about the company's future financial performance. He calls it the "market signals approach," and it provided a lightning bolt of insight for me.
Rappaport showed that, in setting a price, the market offers a clear signal that can inform operational and financial decisions. You start by using analysts' reports and other sources to gauge the consensus expectations for value drivers — sales growth, operating profit margins, cost of capital and other factors that determine cash flows. Think of this step as determining where the bar is set for a high jumper; you simply want to understand what the market anticipates. Next, compare the expectations of the market with those of management. Gaps between those sets of expectations supply management with a basis for decision making. Rappaport made no claims that the market is correct, only that it contains information managers can use.
I have walked many management teams through a market-signals analysis and the results have surprised them almost without fail. Executives have a sense of where their stock should be, but their gut view is generally infected by a range of psychological biases and overly simplistic analysis. Even today, twenty-five years later, a well-executed market-signals analysis provides management with a great deal of insight.
Rappaport's article was published shortly after I graduated from college. As a liberal arts major with very limited exposure to business or finance, I found the stock market fascinating but bewildering. My confusion was only compounded by reading the remarks of the business press and analysts. The commentary about Wall Street was then, as it is today, filled with rules of thumb, tales from the trenches, and Monday-morning quarterbacking. Rappaport offered me clarity in my state of confusion.
I went into the investment business, where the market-signals approach is arguably even more useful than it is for executives. Rather than looking for a gap for a single company, an investor can cruise markets seeking gaps for lots of companies. You have buy candidates in the cases where the price implies expectations that are too low, and you have sell candidates where expectations are too high.
If you've gotten to this point, I suspect you're thinking: "it seems obvious that you should use this approach." But very few executives or investors do. In fact, I believe that the failure to distinguish between fundamentals and expectations — which is precisely the point of a market-signals analysis — is the single most common error in the investment business.
I immediately incorporated the expectations approach into my work as an analyst and it is a cornerstone of the course on security analysis that I teach to MBA students. I was fortunate to be able to collaborate with Rappaport on a book called Expectations Investing that tailored the market signals approach to investors. Still, this powerful idea remains remarkably underutilized.


Source:hbr.com