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How many times have we seen it?

One company delivers a stellar quarterly earnings report, highlighted by, say, a sharp 50% increase in quarterly earnings. Yet, despite the good news, Wall Street reacts with a yawn -- or, worse yet, sends the shares tumbling lower.

At the same time, another company can report a steep 50% decline in profits, but somehow the shares manage to shrug off the poor results and race higher.

Clearly, stock prices are influenced by factors outside of a firm's financial performance. Expectations always come into play.

Looking past earnings
As the title implies, expectations are at the heart of Expectations Investing, an eye-opening work co-penned by Alfred Rappaport and Michael Mauboussin.

According to the authors -- and many of us here in Fooldom -- a company's stock price is simply a derivative of its long-range cash flow outlook. As such, short-term quarterly earnings reports (the focus of most investors, analysts, and financial journalists) typically have little bearing on overall returns.

Not surprisingly, the book argues that traditional valuation metrics like P/E ratios are not particularly indicative of where a stock is headed. If for no other reason, such analytical shortcuts omit a very important part of the bigger equation -- a firm's capital requirements and the cost of that capital.

In their search to find fast-growing companies, few investors stop to ask how much the latest uptick in profits cost. In many cases, incremental growth is the result of increased expenditures. If the discounted present value of the excess cash flow doesn't keep pace with the present value of the cash outflow (from added spending), then management is not creating shareholder value, but destroying it.

In other words, "when new investments yield a return below the cost of capital, shareholder value decreases, even as earnings increase." Even if earnings growth does lead to a corresponding increase in shareholder value, the shares can still retreat if the numbers prompt Wall Street to ratchet down future expectations.

Instead of blindly chasing growth, the key to uncovering winning stocks is to find companies that are poised to hurdle the expectations that have been set for them. Bottom line, when Wall Street is forced to re-examine its thinking and raise its long-term forecast for a company, then a higher stock price can't be far behind.

Working backwards
So, how do we identify such firms? Rappaport and Mauboussin go to great lengths to answer that question.

The solution lies in the price of the stock itself -- an often overlooked data point from which a treasure trove of information can be gleaned. When interpreted correctly, share prices can tell us exactly how the investment community is expecting a company to perform in the years ahead.

From there, we only need to assess whether the firm is positioned to surpass those expectations. If so, then the crowd must eventually revise its expectations higher, which in turn would lead to an upward adjustment in the share price.

To determine what a company's expectations are today, Expectations Investing relies heavily on proven discounted cash flow (DCF) valuation techniques -- but turns them completely upside down.

Instead of using long-range expectations to calculate a fair value, Rappaport and Mauboussin recommend the reverse: Start with the stock's price, and then determine the future cash flow prospects that would justify that price.

Here's a scaled-down example using asset management firm Legg Mason (NYSE:LM), which happens to be Mauboussin's employer.

Based on a discount rate of 10% and a cash flow growth rate of 15% over the next five years (leveling off to 9% in years six-10 and 3% thereafter), I have penciled in a fair-value estimate of $106 per share.

With the stock currently trading below $90, Legg Mason might be moderately undervalued with a considerable margin of safety. However, there is always the risk that my assumptions could be well off the mark. Fortunately, Expectations Investing tackles the problem from another angle and removes that uncertainty.

Rather than projecting future cash flow, I simply have to decipher the expectations that have been baked into the current price. If the stock appears capable of handily outperforming its price implied expectations (PIE), then it might be a solid buy candidate.

Digging beneath the numbers
In the case of Legg Mason, based on the same discount rate of 10%, the company would only need to deliver a growth rate of 12% over the next five years (dropping to 7% the following five) to justify its current price of $88.42. All things considered, I believe the company can more than meet those demands over the next decade.

Of course, this is an extremely simplified example that barely scrapes the tip of the Expectations Investing iceberg. The authors delve deeply into the factors that influence future cash flow: sales growth, operating margins, taxes, and capital expenditures.

From there, the book explores different variables that might trigger a revision in one of the four drivers above. For example, sales growth triggers might include changes in volume, price/product mix, operating leverage, and economies of scale.

In the end, the sharper the discount between a stock's expected value and current price, and the shorter the time period until the market adjusts its expectations and the price "converges" with the expected value, the stronger the stock.

Easy as 1,2,3 .
While learning the intricacies will undoubtedly take some time, the process can be summed up in three easy steps.

  1. Based on the current stock price, estimate what expectations have been implied by the market today.
  2. By digging down into the factors that drive future cash flow, determine what the expectations might be tomorrow.
  3. Use any mismatches as the framework for your buy/sell/hold decisions.

With in-depth discussion of complex topics like the Black & Scholes options pricing model, Expectations Investing isn't exactly light recreational reading. However, Fools who want to sharpen their edge in stock valuation will find it a real page-turner.

Learn to expect the unexpected, and you are well on your way to earning superior investment returns.

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Fool contributor Nathan Slaughter owns none of the shares mentioned. The Fool's disclosure policy contains no surprises.