Forecasting a company's next ten years is hard, and most forecasts are wrong. There is a more modest question that is often more useful: what does the current price already assume? Answer that, and your job becomes judging whether those assumptions are too high or too low.
Reverse valuation takes the market price as given and solves for the growth, margins or cash flows that would justify it. If the implied expectations look easy to beat, the stock may be attractive. If they require near-perfect execution for a decade, the risk is on the downside even for a great company.
What to look at
- Start with enterprise value and a reasonable discount rate.
- Solve for the revenue growth or margin needed to produce that value.
- Compare the implied numbers with the company's history and its industry's best performers.
- A great business priced for perfection can be a poor investment; a mediocre one priced for collapse can be a good one.
- The gap between implied and plausible is your margin of safety, or your risk.
The shape of it
Expectations gap = Your plausible outcome − Market-implied outcome
An example
A stock's price implies 25% annual revenue growth for ten years with 35% margins. Only a handful of companies in history have done that. You may love the product, but you are betting it joins that tiny group.
Where people go wrong
'Priced in' is not the same as 'fairly priced'. Markets can be wrong in both directions for long periods. The point is to know which way you are betting.
This is the question ImpliedLens is named after. Every tool on the site is built to help you answer it: what does the price imply, and is the business likely to beat it?