Have you ever been the last of your friends to see a movie or show that ended up disappointing you? They all raved about it: “It’s straight fire” or “Dead — you gotta see it.” Then, you finally get around to it, and think, “Yeah that was cool, but I wouldn’t call it a must-see.”

This same thing can happen in investing. At its core, investing represents participation in potential future cash flows and income. And, thus, valuing many investments means you have to translate the future back to a value today. As we talked about last week, interest rates are a key component of this valuation process (the higher interest rates are, the lower values will be today, all else being equal). The other two main parts are:

1. Expectations of earnings and growth

2. Sentiment on how sure it feels those cash flows would be received in the future

So like the movie that got talked up, stocks, for example, can be, too. Expectations are a key part of assessing an investment because you have to come up with some expectation of what earnings or income will be in the future, including how much they will grow. That alone can be tough to get right. And, in many ways, if you are right, but all market participants agree, then any waver from expected progress a company has can send its stock price down in the short term. Even if earnings are good, if they’re already expected, the bar is high. 

The market likes few things more than a positive surprise, but really dislikes negative surprises. It doesn’t mean, of course, that you can’t or shouldn’t invest in things that have strong earnings. But knowing if it’s widely known or not can help you assess whether a stock price (or the value of anything) already reflects really good future news or not. 

How do you do this? For publicly traded stocks, at a high level, you can look up analysts’ earnings estimates and also review historical earnings data. That can help form a picture of what others, who analyze stocks for a living, are thinking — and give you an idea of what expectations are already in the price.

I also mentioned sentiment. While this is a little more based on a feeling, there are some ways you can assess it. It’s essentially how excited or confident the market is about a company’s prospects. Meaning, expectations of earnings can be positive, but if the likelihood of this actually happening seems iffier, the current price may not fully reflect those expectations. Whereas, if they seem very sure, the current price may actually reflect a bit more than the expectations alone — this is called a premium.  

One way to see this in an investment is through price multiples. For stocks, if you take the current price, and divide it by the expected earnings for the next year, you’ll get the forward P/E ratio of the stock (you can also usually look up this number). The number alone tells you how many “turns” the price is relative to expected earnings. But, it is more meaningful when compared to something else. For example, comparisons of this ratio are often to its own history, to other companies in the same industry, or relative to the broader market’s version of the same ratio. 

Let’s look at two companies in the same industry, as an example:

• Company A has a P/E ratio of 13x, with an earnings per share for 2023 of $7.3 

• Company B has a P/E ratio of 10x, with an earnings per share for 2023 of $36.2

In the example above, Company B has a more volatile earnings history, while Company A has been able to more consistently deliver for its shareholders. So while one would expect the same multiple to apply, and the difference in price coming from expectations of earnings alone, this shows how Company A commands a higher valuation, despite Company B earning a lot more. 

In general, the higher the relative P/E is when making a comparison, the higher the valuation is (all else equal)... the more likely sentiment is better for that one. So ask — is it deserved?

There are other types of multiples, of course, and some are better applied to certain industries than others. For example, the financial services sector has certain attributes, such as higher government regulation and their organization of debt, that make evaluating the companies within it unique. As a result, price-to-book ratio (P/B) can be a more applicable measure (or multiple) of comparison for this sector (P/B ratio compares the price to its market capitalization*).

In summary, expectations and sentiment really impact the value of investments. And it's not very different to how we assess things in our own lives. From movies and books to people and jobs — you could say expectations and sentiment also impact their values. Like stocks, they are investments we make, of our time and energy — and all are deserving of careful assessment.

*Market capitalization = number of shares outstanding times the price of the stock

Source: Robinhood Financial

For more Investor’s Guilds, see here.