A Different Way to Look at Future Performance

Whether all investors realize it or not, stock prices ought reflect the future performance of a company, not the past performance. It is easy to lose sight of this simple notion when the only data we have available is that which describes operations that have already occurred, particularly since we have an enormous amount of such data. But in reality the only reason past performance matters is because it is usually indicative of what will happen in the future. For instance, a PE ratio of 20 times prior twelve month’s earnings might seem far too high for a particular company, but five years down the road, with the benefit of hindsight, we may be able to see that the valuation was actually quite reasonable.

The problem we run in to when trying to value a company based on future performance is that future performance is, simply, unknown. We can make educated guesses, but nobody really knows for sure. The Required Business Performance (RBP) methodology is an excellent way to cope with the truism that the future is always uncertain because it approaches the investment decision in a very different way. Rather than guessing what future performance will be and then assigning an appropriate value, RBP asks “What is the level of future business performance that is required to support the current price of the stock?” Then, after calculating this level, RBP asks “What is the likelihood that management can deliver this level of performance?”

Transparent Value, which created the RBP Methodology, has a favorite aphorism: The key to successful investing is the ability to benchmark management’s ability to perform in the future against the required business performance implied by the price of the stock. That is, instead of worrying about the infinite number of performance scenarios that could result in the future, let’s focus on the one scenario that represents the consensus of market participants – the one implied by the current stock price. After all, if we buy the stock at the current price, we are implicitly agreeing that this market consensus either equals or understates what will in fact happen in the future.

The benefit of taking this approach is that it allows the investor to a) focus only on information that is known with certainty and b) ask logical, relevant, business-related questions when making the investment decision. For instance, we know with certainty that the current price of Apple stock implies that it will sell 49 million iPods next year – can this be done?

The process turns a very complex and confusing process in to an understandable decision. It makes stock prices more meaningful and more transparent. This in turn makes the market more accessible to the average investor.