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One of the most difficult questions in investing sounds trivial at first: When should I buy a stock? Many investors implicitly answer this question with a forecast. They try to assess whether the market will rise or fall in the short term, whether a correction is imminent, or whether the price might drop even further. The problem with this way of thinking is well known. Short-term price movements are virtually impossible to predict reliably. Even professional investors regularly get it wrong.
That’s exactly why I prefer to work with a different approach: scenarios instead of forecasts. The difference may seem small at first glance, but it changes the entire decision-making framework for the portfolio. A forecast attempts to predict what will happen. A scenario describes several plausible developments and defines how to act in light of these possibilities. The central question is therefore no longer, “What will the market do?” but rather, “What developments are plausible—and what valuation ranges result from them?”
The key point here is that scenarios do not start with price targets. They start with fundamental data. Only once it is clear which operational development is plausible and how the market typically values that development do meaningful entry and exit zones emerge.
The process always follows the same sequence: determine business quality, define earnings drivers, formulate operational scenarios, derive valuation ranges, and use these to develop specific price zones. This logic may seem analytical at first, but in practice it is surprisingly robust because it ties investment decisions to a company’s structural characteristics rather than to short-term market sentiment.
A helpful first step is a simple classification: Where does a company’s greatest uncertainty actually lie—in its earnings or in its valuation?
In the long term, stock prices are determined by two variables: a company’s earnings and the multiple the market assigns to those earnings. This leads to a simple framework for thinking. If earnings are relatively stable but the valuation fluctuates, it is a valuation case. If, on the other hand, the valuation is relatively stable but earnings can fluctuate significantly, it is more of an earnings or growth case.
This distinction is more important than it initially sounds because it determines how scenarios must be constructed. For quality companies, scenarios arise primarily from valuation ranges. For smaller growth companies, on the other hand, scenarios arise from different earnings trajectories.
A good example of the first case is $HON (+0,02%) (Honeywell International). Honeywell is a classic quality industrial stock with stable returns on capital and moderate growth. Typical key metrics from recent years show a relatively clear profile: revenue growth in the range of about four to six percent, operating margins roughly around 20 to 21 percent, and a free cash flow margin of about 15 percent. Returns on capital have been in the high teens over the long term. The company thus clearly belongs in the category of high-quality industrial stocks, even if individual metrics fluctuate over the business cycle.
Such companies have a relatively stable operating range. What fluctuates more is the valuation the market is willing to pay. Historically, Honeywell has often traded within a valuation range of approximately 23 to 27 on a price-to-earnings ratio, with sometimes significantly lower or higher swings during specific market phases. For scenario analysis, therefore, a pragmatic range of about 21 to 25 is sufficient as a typical valuation zone.
When the share price in my case was just above about 160 euros, this corresponded to a P/E ratio of around 18 and a free cash flow yield in the mid-single-digit range. The market thus treated Honeywell more like a typical industrial stock, even though its returns on capital are structurally higher. This is precisely where the logic of the scenario comes into play. If the quality of the company remains stable but the valuation is significantly below the historical range, an asymmetric situation arises: the downside risk is limited, while a return to normal valuation opens up significant upside potential.
The following scenarios are therefore not precise valuation models, but rather heuristic derivations based on two variables: a plausible earnings trend over the next three to five years and the historical valuation range.
In the bearish scenario, the industrial environment remains weak and the market continues to value the company conservatively. Earnings grow only moderately, perhaps in the range of three to four percent per year, and the multiple remains at around 20. This results in a fair valuation roughly in the range of about $200.
In the neutral scenario, the valuation normalizes back toward the historical midpoint. Operations grow steadily, with earnings growth in the range of six to seven percent per year, and the multiple returns to around 23. In this case, the valuation comes to around $230.
In the bullish scenario, additional structural drivers come into play. Honeywell benefits more significantly from long-term trends such as automation, the digitization of industrial processes, or robust demand in the aerospace segment. Earnings growth could then be more in the range of eight to nine percent per year, while the market once again pays a clear quality premium and accepts a multiple of around 25. This results in a valuation in the range of approximately $250 to $260. These fair-value ranges should be understood as heuristic derivations from the earnings trajectory and historical multiple range, not as precise DCF results.
These scenarios form the basis for specific action zones. The entry price of around 160 euros was clearly below the neutral scenario. In this situation, the position was deliberately built up in full because the share price was already moving within the range of the bearish scenario and thus offered an attractive asymmetric valuation. The downside appeared limited, while a return to the normal valuation range opened up significant potential.
Equally important, however, is the other side of the decision: the exit. Many investors define entry strategies but give little thought to exit zones. Yet the two are closely linked. If scenarios are clearly defined, potential exit zones follow automatically. In my case, these are around 220, 240, and 260 euros, with a one-third reduction in the position at each level. These levels correspond quite precisely to the movement across the scenario range: first the neutral scenario, then a more ambitious quality assessment, and finally a range in which a bullish scenario is already largely priced in. The fair value calculations are based on U.S. dollars, while the exit zones are expressed in euros, as they are based on the actual trading prices at that time.
The price does not have to reach these levels exactly, and I am currently still holding the entire position. These zones do not serve as rigid sell rules, but rather as reference points for valuation. As the valuation rises, the risk-reward ratio deteriorates, even if the company continues to perform well operationally.
A completely different picture emerges with $ERII (+0,68%) (Energy Recovery). The company has an interesting business model centered on energy recovery technology, particularly in the areas of water desalination and water treatment. At the same time, it is significantly smaller and more dependent on individual applications and projects. A large portion of revenue continues to come from the water segment, while new applications in areas such as LNG or industrial pumping systems are still in an early stage of development.
The key uncertainty here therefore lies less in the valuation than in the development of earnings. While the gross margin is very high, the operating and net margins are significantly lower and can fluctuate more widely. However, the key factor is revenue momentum, which has historically fluctuated between years of weaker and significantly stronger growth.
The scenario analysis is therefore primarily based on different growth trajectories over the next three to five years.
In the bearish scenario, growth remains weak. The core business performs steadily, but new applications do not scale. Revenue growth could then be in the range of two to three percent per year, and the fair value would likely be in the range of about 8 to 10 euros.
In the neutral scenario, the core business continues to grow solidly. Revenue and profit rise in the range of about five to seven percent per year, and the fair value is roughly in the range of 14 to 16 euros.
In the bullish scenario, however, new applications begin to scale. Growth in the range of ten to twelve percent per year becomes possible, and the valuation rises accordingly. In this case, the fair value could be in the range of about 22 to 25 euros. The ranges here are deliberately wider than in the Honeywell example because both the earnings trajectory and the valuation can fluctuate more significantly for small-cap stocks.
The initial entry at around 15 euros was thus almost exactly in line with the neutral scenario. That is precisely why the initial position was deliberately small. When the market later corrected sharply downward, the price approached the bearish scenario. During this phase, the position was increased. The result is a position that is currently showing a moderate loss, but whose risk-reward ratio has improved significantly. As long as the bearish scenario path does not materialize fundamentally, adding to the position near the lower valuation zone remains rational because it shifts the position closer to the middle of the scenario range.
This highlights an important distinction. With Honeywell, it is primarily the valuation that fluctuates. With Energy Recovery, it is primarily the earnings trajectory that fluctuates. This distinction determines the entire decision-making framework. Quality companies often move through different valuation phases. Smaller growth companies, on the other hand, move through different earnings trajectories.
As a heuristic, this can therefore be summarized as follows: For quality companies, valuation typically fluctuates. For small-cap companies, earnings typically fluctuate. Anyone who wants to derive scenarios accurately must first understand which of these two variables plays the dominant role.
Scenarios are thus not a rhetorical safety net designed to explain every development in hindsight. They are the structural framework of the decision. They link fundamental data with valuation and translate this combination into concrete zones of action.
A portfolio then no longer consists of individual, spontaneous buying decisions, but rather of a decision-making architecture: Scenarios define valuation ranges; valuation ranges define entry and exit zones; and these zones determine how capital is allocated within the portfolio over time.
This is precisely where the connection to the next part of the series comes in. For even if scenarios are carefully derived, one central question remains: How large should a position actually be? Different uncertainties require different weightings. A quality stock with stable cash flows is typically weighted differently than a small-cap growth stock with a wide range of possible scenarios. The next article will therefore focus on the second level of the decision-making architecture: position sizes under uncertainty—and how scenarios determine not only entry zones but also the allocation of capital within the portfolio.
