Investors observe the markets within a rational expectations framework in which they exploit current available information to predict future stock returns. Taking into consideration accounting-related attributes such as price to book (P/B), price to earnings (P/E), and price to cash flow (P/CF), but also market-related attributes such as firm size, trading volume, and market returns, expectation analysis considers the beliefs of the investors and speculators to best estimate the future direction of stock prices.
Expectation analysis is an investment analysis that enables analysts to forecast the economy’s future direction based on current fundamentals or trends. Given that the accuracy of the estimates cannot be measured when estimates are produced, economic forecasts have to be scientific, that is, formulated by verifiable predictions based on explicitly stated statistical method that can be checked or reproduced. Or else, the validity of the forecasts is at stake and the forecast reliability is an unstable basis for further scientific progress. Considering the current financial environment and the assumptions behind the estimates, expectation analysis constantly monitors the data produced in the form of information available to investors in order to identify any changes in the environment or violation of the analyst’s assumptions.
Expectation analysis is concluded in four stages.
(1) In the first stage, expectation analysis forecasts the broader economic, political and demographic trends. This stage includes assumptions about monetary and fiscal policy, political conditions and initiatives, trade partnerships and others.
(2) In the second stage, expectation analysis relates the macroeconomic forecasts to certain sectors of the economy aiming to identify how GDP components – such as government spending, consumption, investment, and net exports – change over time.
(3) In the third stage, expectation analysis relates the macro and sector forecasts from the previous stages to industry analysis. The microeconomic analysis estimates price elasticity, competitive positioning and other micro and macro trends that are particularly relevant to the industry specialization.
(4) In the fourth stage, expectation analysis adapts economic and industry analysis to the individual firm. Within this context, analysts use the Porter’s Five Forces Model which identifies the bargaining power of suppliers, the bargaining power of buyers, the threat of new entrants, the potential substitutes and the current rivalry as the five forces that may affect the competitive structure of the firm.
After each stage of expectation analysis is concluded, relevant variables are produced in order to be monitored in relation to the forecasts made. In this context, expectation analysis tracks the relationship between the analysts’ estimates and the expected industry performance aiming to weigh the implications of new information on industry analysis and economic outlook. In case of violation of the analysts’ assumptions, estimates are reviewed and adjusted to the new market realities so that investors receive accurate information on the state of the economy and rebuild their rational expectations framework for future stock-market performance.