Return Spread: From IRR to "Expensive or Cheap"

This is the "heart" of the entire engine. It judges expensive/fair/cheap not from the level of the P/E, nor from the mood of a rally or selloff, but by computing one simple difference—the Return Spread.

A Single Subtraction

Return Spread = probability-weighted IRR (the expected annualized return on the investment) - Required Return (your pass/fail bar). A positive difference means the return exceeds the hurdle—cheap; a negative one means it does not match the risk—expensive. With that single subtraction, "cheap" stops being a feeling and becomes a number you can compute and revisit.

Mechanical Grading: Same Spread, Same Label

The engine uses a calibrated lookup table to map the Return Spread mechanically onto a valuation state: the same spread always yields the same label, regardless of how the question is phrased or what mood you are in. The specific bucket thresholds are part of the engine's internal calibration; for your purposes, just remember the direction—the more positive the spread the cheaper, the more negative the more expensive. This mechanical consistency guarantees that the same inputs produce conclusions on the same basis.

• Clearly positive spread, and the larger it is → the cheaper (undervalued / deeply undervalued).
• Spread near zero → Fairly Valued.
• Negative spread, and the more negative → the more expensive (somewhat expensive / expensive / bubble territory).

Why a "Low P/E" Does Not Mean Cheap

A company at a P/E of 10 that has stopped growing may have a very low IRR and a negative Return Spread—and thus be expensive; a company at a P/E of 30 whose earnings compound rapidly may have a very high IRR and a positive Return Spread—and thus be cheap. The engine looks at "whether the expected future return from buying at the current price is enough," not at the level of a static multiple.

“Whether something is cheap is measured against future returns, not against an isolated P/E number.”— Institutional Research Principle

How It Shows Up in the Report

The report's core panel shows the Return Spread and its corresponding valuation state directly. Once you understand it, you have grasped the full logic behind the engine's conclusion. To understand its left-hand side (probability-weighted IRR), see the next article, "IRR Explained"; for the right-hand side (Required Return), see the previous one.