November 2010
Intermediate to advanced
272 pages
6h 47m
English
4
The Expectations Treadmill
The first two cornerstones of finance defined what drives real value creation in a corporation. The third cornerstone, the expectations treadmill, explains how that value is reflected in the returns that equity investors earn.
The return on invested capital (ROIC) that a company earns is not the same as what its shareholders earn. Suppose a company can invest $1,000 in a factory and earn $200 every year. The first investors in the company pay $1,000 for their shares, and if they hold the shares they will earn 20 percent per year ($200 divided by $1,000).
Suppose then, after one year, the investors decide to sell their shares and find buyers who pay $2,000 for the shares. Because of the higher price, and assuming it doesn't rise further, these new buyers will earn only 10 percent per year on their investment ($200 divided by $2,000), compared to the original owners who earned a 120 percent return (ROIC of 20 percent and share-price appreciation of 100 percent).
Although all the investors collectively will earn the same return as the company (on a time-weighted average), individual groups of investors will earn very different returns because they pay different prices for the shares based on their expectations of future performance.
A useful analogy, the speed of a treadmill represents the expectations built into a company's share price. If the company beats expectations, and if the market believes the improvement is sustainable, its stock price goes ...
