2 minute read / Oct 19, 2021 / books /
Using the Reversal Mental Model to Invest Better
Reversing a problem is a common mental model for thinking about a challenge in a novel way. Especially in investing.
Google’s share price is $2863.55 as I write this. Is it a good price to buy?
The traditional way of thinking would lead one to build a bottoms-up model with a few assumptions and compare the output to the price.
But that approach ignores some critical information: the price. Price implicitly conveys the market’s expectations: how the company will grow, how valuable it will be, how strong the management team is. Most public companies are valued on the next ten years’ discounted cash flows. As Claude Shannon said, information is surprise.
If instead, I start with the price and then build the model in reverse to compare the expectations of the market to my thoughts about the company, I quickly see whether my beliefs about a company differ from the market broadly.
Michael Mauboussin’s Expectations Investing advocates reversing investment decisions this way: calculate the market’s expectations and line them up with yours to determine if you ought to invest. In other words, build the DCF to justify the price and then compare those assumptions to yours.
Expectations investing is ubiquitous in Startupland, especially today when investors value exceptional startups at 100x ARR. Startups who command premium valuations have information baked in the price.
Unlike the public market, which might constitute thousands or tens of thousands of entities pricing a stock, in Startupland, the valuation of a company can be set by a single investor, so perhaps there’s less information in a price.