Top Banner
- 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: VALUATION MODELS: ACCURACY AND PREDICTIVE ACCURACY AND PREDICTIVE CAPABILITY CAPABILITY (A WORK-IN-PROGRESS) (A WORK-IN-PROGRESS) Designed to be Challenging and Designed to be Challenging and Provocative Provocative Stamford Analyst Society May 25, 2005 By Rawley Thomas President LifeCycle Returns, Inc. [email protected]
72

- 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

Dec 16, 2015

Download

Documents

Susana Eggers
Welcome message from author
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Page 1: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 1 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

VALUATION MODELS:VALUATION MODELS:ACCURACY AND PREDICTIVE ACCURACY AND PREDICTIVE

CAPABILITYCAPABILITY(A WORK-IN-PROGRESS)(A WORK-IN-PROGRESS)

Designed to be Challenging and ProvocativeDesigned to be Challenging and Provocative

Stamford Analyst Society

May 25, 2005By

Rawley Thomas

President

LifeCycle Returns, Inc.

[email protected]

Page 2: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 2 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

THE CONCEPT OF VALUE MANAGEMENTTHE CONCEPT OF VALUE MANAGEMENT A strong correlation exists between enterprise value

and the spread between CER (cash economic return) and cost of capital

Econometric DCF models can be built and validated against historical data to quantify this correlation and identify the key operating drivers which most significantly impact value

Managements can use these models to analyze their own corporate performance and to improve their decision making and value generation

Portfolio managers can use these models for buy / sell decisions

Page 3: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 3 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

DISCONNECT DISCONNECT BETWEEN VALUE BETWEEN VALUE

MANAGEMENT AND MANAGEMENT AND PORTFOLIO PORTFOLIO

APPLICATIONAPPLICATION

Page 4: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 4 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

UTILIZATION OF ECONOMIC RATE OF UTILIZATION OF ECONOMIC RATE OF RETURN BASED DCF VALUATIONSRETURN BASED DCF VALUATIONS

Academic finance teaches that corporations create shareholder value when investing in projects which produce rates of return above the cost of capital

Yet, most professional money managers primarily employ P/E’s, EPS surprises and other metrics which fail to relate directly to the above fundamental finance principle

Why don’t most all portfolio managers utilize rate of return on capital based DCF techniques as their primary (or even exclusive) criteria for investment decisions?

Hypothesis Academics and practitioner oriented vendors have failed to

demonstrate conceptually sound, overwhelming empiricalempirical evidence that either EVA® or DCF intrinsic valuation techniques based on corporate rate of return spreads over the cost of capital are superior to simple multiples in explaining stock price levels and total shareholder returns.

Page 5: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 5 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

OTHER HYPOTHESES FOR THE DISCONNECT BETWEEN OTHER HYPOTHESES FOR THE DISCONNECT BETWEEN CAPITAL BUDGETING PRINCIPLES AND PORTFOLIO CAPITAL BUDGETING PRINCIPLES AND PORTFOLIO

DECISIONSDECISIONS

Failure to decompose the problem into separable component pieces– Solve the price level = PV of cash flows empirically first, before attacking the

price change problem (academics usually employ multiple regression techniques of price changes related to other variables)

– Separate the validity of the cash flow forecast from the empirical validity of the terminal value structure

– Separate the migration of price toward intrinsic value and intrinsic value toward next year’s price

– Separate technical (behavioral finance sentiment) pressures from intrinsic valuations as anchors – wide-spread academic belief in the strong form instantaneous efficient markets precludes their openness to consider counter evidence

Failure to develop measures of goodness which enable comparative empirical testing of different models and associated parameters

– Measure the empirical accuracy of intrinsic value models against actual stock price levels (without analyst intervention)

– Measure the differences between “Winner” and “Losers” – their means and their distributional “risk” characteristics

Page 6: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 6 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

VALUATION MODEL VALUATION MODEL AND SECURITY AND SECURITY

ANALYSIS ANALYSIS PROCESSESPROCESSES

Page 7: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 7 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

LCRT PERCEPTION:LCRT PERCEPTION:STRATEGIC POSITIONING AND EMPHASISSTRATEGIC POSITIONING AND EMPHASIS

ONONINDIVIDUAL FIRM SECURITY ANALYSISINDIVIDUAL FIRM SECURITY ANALYSIS

VERSUSVERSUSVALUATION AND STOCK SELECTION QUANTITATIVE MODELSVALUATION AND STOCK SELECTION QUANTITATIVE MODELS

0102030405060708090

100110

0 10 20 30 40 50 60 70 80 90 100 110

Valuation and Stock Selection Quantitative Models (%)

Ind

ivid

ua

l Fir

m S

ec

uri

ty

An

aly

sis

(%

)

Zacks, First Call

Morgan Stanley

Merrill Lynch

CSFB HOLT & AFG

LifeCycle Returns

SchwabRetail

“Sweet Spot” ?

Hypothesis: Moving from heavy individual security analysis in the upper left toward more model based valuations in the lower right may enable the security

analysis function to add more value and become more scaleable, IF the valuation model employed is

more robust, accurate, and predictive. Analysts spend more time on material valuation issues and

strategic forecasts.

Page 8: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 8 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

LCRT SIMPLIFIED VIEW OF THE LCRT SIMPLIFIED VIEW OF THE ROLES FOR SECURITY ANALYSTSROLES FOR SECURITY ANALYSTS

Simplified Value added Roles in the Investment Process– Override historical raw financial data and selected drivers of

cash economic return and debt to properly reflect economics and valuation of each firm

– Forecast discontinuities of performance between history and the future based on an assessment of competitive strategy

– Employ empirically validated most accurate structure of valuation models as the terminal values in the forecasts

Properly implemented, these simplified roles promise the possibility of both increasing the value added of the security analysis function and its scalability from 20-25 to 75-100 firms per security analyst

– Encourages the security analyst to focus on the most value relevant issues

Page 9: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 9 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

How Many Resources Does Your Institution Devote to Reduce the Model How Many Resources Does Your Institution Devote to Reduce the Model Risk* of Your DCF Terminal Value Assumptions Through Empirical Risk* of Your DCF Terminal Value Assumptions Through Empirical

Validation? How Do those Resources Compare to Its Valuation Impact?Validation? How Do those Resources Compare to Its Valuation Impact?

Typical % Valuation Impact

85

15 TerminalValue(DCF orMultiple)

Forecast

Typical % Resources Devoted to Accurate Forecasts

85

1

14Forecast

DCF TerminalValueMultipleTerminal Value

*Susan Mangiero, “The Risks of Ignoring Model Risk (New),” Chapter 5B, in Risk Management for Pensions, Endowments, and Foundations, Wiley, Forthcoming November 2004, pp. 5B•1-4.Susan Mangiero, “Financial Model Risk Looms Large,” The Investment Lawyer, November 2002, pp. 1-6.

Page 10: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 10 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

COMPARISON OF COMPARISON OF VALUE BASED VALUE BASED MANAGEMENT MANAGEMENT FRAMEWORKSFRAMEWORKS

Page 11: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 11 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

SIMILARITIES OF CSFB HOLT, AFG SIMILARITIES OF CSFB HOLT, AFG (Applied Financial Group) AND LCRT(Applied Financial Group) AND LCRT

Gross Cash Flow to Inflation Adjusted Gross Cash Investment Annual Performance Measure (HOLT CFROI®, AFG Economic Margin, LCRT CER Cash Economic Return)

– Reflects IRR of Projects in Place (Treats Corporation As a Capital Budget Project)

– Eliminates Material Cash and Inflation Distortions of Traditional Accounting Measures

– Directly Comparable Over Time and Across Companies and to the Investor’s Cost of Capital Requirements

Market Derived Real Discount Rates (Costs of Capital) Sustainable Growth Rates Fading Returns and Growth Rates Define Cash Flows in Intrinsic

Valuation Model Creates Spot Intrinsic Value Model Each Year for Each Company Similar inputs, outputs, and sensitivities

Page 12: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 12 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

SIMILARITIES BETWEEN STERN SIMILARITIES BETWEEN STERN STEWART AND LCRTSTEWART AND LCRT

GAAP Income, accounting rates of return, EPS growth and value expressed in simple multiples fail to reflect the fundamental economics of companies

Fundamental economics require comparing the rate of return on operating assets which a business achieves to its cost of capital

– Returns on Total Capital (Debt and Equity) are more appropriate than leveraged returns on equity for non-financial firms

– Valuation models should focus on enterprise values, subtract debt, and divide by shares to determine equity value per share; they should not attempt to estimate equity values directly

Excess returns over the cost of capital do not last forever Both methods produce a rate of return and a change in intrinsic

value over time.

Page 13: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 13 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

CONCEPTUAL DIFFERENCES BETWEEN STERN CONCEPTUAL DIFFERENCES BETWEEN STERN STEWART AND LCRTSTEWART AND LCRT

Stern Stewart Company rate of return based on

(RONA)1

– Net Assets Include Goodwill Traditional CAPM Nominal Weighed

Average Cost of Capital EVA®2 = (RONA – CAPM Cost of

Capital) * Depreciated H$ Net Assets Excess returns continue for “T” years,

after which spread over the cost of capital drops to zero

Stream of EVA®’s produces a current intrinsic value

LCRT CER3 =

– Gross Assets Exclude Goodwill4

Real Market Derived Investor’s Discount Rate

Cash Value Added = (CER – Market Derived Discount Rate) * C$ Gross Invested Capital

Returns fade toward a company specific CER Fade-To

DCF produces a current intrinsic value

1 Equivalently, Total Capital Employed = Debt + Equity = Net Assets

2 EVA® is a registered Trademark of Stern Stewart.

3The ratio version of CER with sinking fund depreciation closely parallels the IRR version for positive cash flows, but, unlike the IRR version, continues to calculate for start-ups and firms in financial distress, when the gross cash flow becomes negative. Sound return performance measures must calculate from boundary to boundary of the universe.

4Effect of Goodwill included in the valuation as the increase in debt assumed or shares exchanged. Including Goodwill in the C$ Gross Assets biases the operating return and likely returns on incremental investments. Goodwill does not require cash to replenish it as with other operating assets.

Net Operating Profit After Tax

Depreciated Historical Dollar Net Assets

Operating Gross Cash Flow - Sinking Fund Depreciation

Constant $ Gross Invested Capital

Page 14: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 14 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

EMPIRICAL DIFFERENCES BETWEEN EMPIRICAL DIFFERENCES BETWEEN STERN STEWART AND LCRTSTERN STEWART AND LCRT

Stern Stewart Empirical Evidence relies on Market

Value Added versus EVA® scatter correlations on Russell 3,000, both on individual company basis and portfolio of companies basis

LCRT Empirical Evidence relies on tracking

error of intrinsic spot value versus actual price @ Fiscal Year + 3 Months to compare multiple models and various parameters for each model with full transparent audit trails on entire universe of about 30,000 company-years

– LCRT 1st Generation– LCRT without enhancements– LCRT without non-recurring add-back– LCRT 2nd Generation Research Model5

– Residual Income (from joint research with Sally Webber from NIU, based on Quest for Value.)

– Free Cash Flow– Feltham-Ohlson

5Treats equity as an option on the returns, growth, size, and capital structure of each firm, based solely on historical data without analyst intervention. Since the LCRT research model places all the risk in the cash flows, it successfully employs a single discount rate each year for all firms in the super sector, without systematic model structural errors in the Susan Mangiero Model Risk sense.

Page 15: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 15 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

MEASUREMENTS MEASUREMENTS ILLUSTRATEDILLUSTRATED

Page 16: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 16 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

IN A CAREFULLY IN A CAREFULLY CONTROLLED CONTROLLED

EXPERIMENT IN AN EXPERIMENT IN AN ECONOMICS ECONOMICS

LABORATORY, VERNON LABORATORY, VERNON SMITH et. al. SMITH et. al.

DEMONSTRATES DEMONSTRATES SIGNIFICANT SIGNIFICANT

DIFFERENCES OF TRADED DIFFERENCES OF TRADED PRICES FROM KNOWN PRICES FROM KNOWN

INTRINSIC VALUESINTRINSIC VALUES

Vernon L. Smith, Gerry L. Suchanek, and Arlington W. Williams, “Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets,” in Vernon Smith, Papers in Experimental Economics, Cambridge University Press, Cambridge, 1991, pp. 339-371, chart from p. 352.

Page 17: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 17 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

NOTICE THE SAME PATTERN IN AN INTRINSIC VALUE CHART NOTICE THE SAME PATTERN IN AN INTRINSIC VALUE CHART WHICH ENABLES US TO VISUALIZE THE MEASUREMENT OF WHICH ENABLES US TO VISUALIZE THE MEASUREMENT OF

ACCURACY OF A DCF MODEL PRICE ACCURACY OF A DCF MODEL PRICE LEVEL LEVEL FOR HPFOR HPUSING ONLY ACTUAL REPORTED FINANCIAL DATA AND THE SAME GLOBAL USING ONLY ACTUAL REPORTED FINANCIAL DATA AND THE SAME GLOBAL

PARAMETERS ACROSS THE ENTIRE UNIVERSE TO DRIVE A MECHANICAL LIFE PARAMETERS ACROSS THE ENTIRE UNIVERSE TO DRIVE A MECHANICAL LIFE CYCLE FORECAST OF CASH FLOWS FOR EACH COMPANYCYCLE FORECAST OF CASH FLOWS FOR EACH COMPANY

Notice the large high low variation around the intrinsic valuations,

providing opportunity for profitable trading

The Absolute “Tracking” Error Intrinsic Value vs. Actual Equals the Absolute Geometric Mean Error

Between The Intrinsic Value Red Line And Closing Prices at Fiscal Year + 3 Months

(hollow circles) Over the Number of Years

LCRT

Residual Income

LCRT15.2

Residual Income65.2

Page 18: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 18 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

FOR HEWLETT-PACKARD, A FREE CASH FLOW MODEL FOR HEWLETT-PACKARD, A FREE CASH FLOW MODEL DISPLAYS LOWER ACCURACY THAN LCRTDISPLAYS LOWER ACCURACY THAN LCRT

(OF COURSE, H-P IS ONLY A SAMPLE OF ONE)(OF COURSE, H-P IS ONLY A SAMPLE OF ONE)

LCRTFree Cash Flow

LCRT15.2

Free Cash Flow23.5

Absolute “Tracking” Error

Page 19: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 19 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

SEVERAL PROFESSORS ARE SEVERAL PROFESSORS ARE COLLABORATING WITH LCRT TO COLLABORATING WITH LCRT TO

DETERMINE THE ROBUSTNESS AND DETERMINE THE ROBUSTNESS AND ACCURACY OF TRADITIONAL MODELS AS ACCURACY OF TRADITIONAL MODELS AS

NULL HYPOTHESESNULL HYPOTHESES

Sally Webber of NIU and Doug Clinton of NIU

– EVA® or Residual Income Models

– Feltham-Ohlson Model

Adam Gehr of DePaul

– Dividend Discount Models

Page 20: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 20 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

CONCEPTUAL CONCEPTUAL DIFFERENCES DIFFERENCES

BETWEEN MODELSBETWEEN MODELS

Page 21: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 21 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

TESTED MODELSTESTED MODELS

8 X EBITDA

Feltham-Ohlson

Residual Income

Free Cash Flow

LCRT

Page 22: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 22 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

COMPARISON OF FELTHAM-OHLSON COMPARISON OF FELTHAM-OHLSON AND FREE CASH FLOW PERPETUITYAND FREE CASH FLOW PERPETUITY

Feltham-Ohlson Based on market value of

equity/ operating assets regressed against return on assets, change in return on assets, and growth rate in assets

From Jing Liu and James A. Ohlson, “The Feltham-Ohlson Model: Empirical Implications,” Journal of Accounting, Auditing and Finance, 2000, v15 [3, Summer], pp. 321-331, especially p. 326-327.

Programmed with the aid of Sally Webber, Accounting Professor, Northern Illinois University

Free Cash Flow Perpetuity Based on growing free cash

flow for T years and capitalizing the terminal year’s free cash flow into perpetuity

Free cash flow = income after taxes + depreciation and amortization – non-operating items after tax – normalized capital expenditures – working capital additions

The terminal year’s cash flow is capitalized by a CAPM nominal discount rate less a nominal growth rate

From specifications by Dan Van Vleet of Willamette

Page 23: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 23 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

COMPARISON OF RESIDUAL COMPARISON OF RESIDUAL INCOME AND LCRTINCOME AND LCRT

Residual Income From PV of growing excess

residual income (EVA®) for T years plus release of capital at terminal value employing a CAPM cost of capital

Bennett Stewart, The Quest for Value, Harper Business, 1991, especially p. 324-325.

Programmed with the aid of Sally Webber, Accounting Professor, Northern Illinois University

LifeCycle Returns (LCRT) From PV of net cash flows for

50+ years using a market derived discount rate

Net cash flows derive from fading growth rates and cash economic returns applied to constant dollar gross investment less replacement assets less growth in gross investment

See Bartley J. Madden, CFROI Valuation: A Total System Approach to Valuing the Firm, Butterworth-Heinemann, Oxford, 1999 and LCRT.com

Page 24: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 24 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

MOST ASSETS PRODUCE A NEARLY LEVEL USEFUL OUTPUT UNTIL FAILURE, INSTEAD OF THE STRAIGHT LINE OR THE

DECLINING BALANCE CURVE REFLECTING DEPRECIATED PLANT

Output

Time

(2) Most Assets Produce Nearly Level Output…

Until Failure

(1) Constant Output = Constant Dollar Level Annuity

Economic Life

(3) Straight Line Depreciation Net Plant

(4) Accelerated D

epreciation Net Plant

Failure (One Horse Shay)

(Economic Value Added Im

plicit Assumption)

Page 25: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 25 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

TRADITIONAL ACCOUNTING MEASURES FIRST TRADITIONAL ACCOUNTING MEASURES FIRST UNDERSTATE AND THEN OVERSTATE ECONOMIC UNDERSTATE AND THEN OVERSTATE ECONOMIC

RETURNS AS ASSETS AGERETURNS AS ASSETS AGE(ASSUMING CONSTANT OUTPUT = CONSTANT DOLLAR LEVEL ANNUITY)(ASSUMING CONSTANT OUTPUT = CONSTANT DOLLAR LEVEL ANNUITY)

(A DESIRED ANNUAL PERFORMANCE MEASURE REFLECTS THE PROJECT IRR)(A DESIRED ANNUAL PERFORMANCE MEASURE REFLECTS THE PROJECT IRR)

NOTE: The Annual CER

each and every year precisely equals the IRR of the project.

-$10,000

PROJECT

$1,740

Life = 8 Years

IRR = 8.00%

Annual Performance Measures of Project

Year

1 2 3 4 5 6 7 8

Income 490 490 490 490 490 490 490 490

Depreciation 1,250 1,250 1,250 1,250 1,250 1,250 1,250 1,250 Gross Cash Flow 1740 1740 1740 1740 1740 1740 1740 1740

Gross Plant 10000 10000 10000 10000 10000 10000 10000 10000

Accumulated Depreciation 1250 2500 3750 5000 6250 7500 8750 10000

Net Plant 8750 7500 6250 5000 3750 2500 1250 0

Return on Net Assets =

RONA = Income/Net Plant 5.60% 6.53% 7.84% 9.80% 13.07% 19.60% 39.20% ∞

Cash Economic Return

(CER) 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%

Difference -2.40% -1.47% -0.16% 1.80% 5.07% 11.60% 31.20% ∞

Return on Gross Assets 17.40% 17.40% 17.40% 17.40% 17.40% 17.40% 17.40% 17.40%

Page 26: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 26 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

Income

+ Depreciation and Amortization

+/- Inflation Adjustments

+/- Finance / Non-Operating Expense Adjustments

Assets

+Accumulated Depreciation

+Inflation Adjustments

+/- Finance / Non-Operating Balance Sheet Adjustments

Cash Economic Return (CER)*

Constant Dollar Gross Asset Base

Super Sector CER Fade-To

Company Cash Economic Return (Fade From)

Company Cash Economic Return Fade-To

CER Fade Rate

Super Sector Growth Fade-To

Company Past CapEx Real Growth Rate and Real Sustainable Growth Rate (Fade From)

Super Sector Gross Asset Growth Fade Rate

Company Specific Real Investors’ Discount Rate, Adjusted for Leverage, Asset Mix, and Life

= Enterprise Intrinsic Value

+ Cash – Debt

= Equity Intrinsic Value

⁄ Number of Shares

= Intrinsic Value Per Share

LCRT FRAMEWORKLCRT FRAMEWORKAccounting

Constant Dollar Cash

Economic Cash Real Rates of Return on Un-

Depreciated Gross Assets (Reflecting Real

IRR of all Projects Currently in Place)

Valuation

Asset Mix

Asset Life

Life Cycle

Valuation

Model

Super SectorsIndustrials

UtilitiesFinancials

(*Real ROE)

Page 27: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 27 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

Income $206

A: Eliminate Non-Operating Special Extraordinary Items After Tax 33

Items (-) Non-operating Expense After-Tax (16)

B: Translate to Cash Non-Cash Charges 333

C: Restate for Inflation Inflation Gain on Non-Fixed Assets 14

D: Eliminate Leverage After-Tax Interest (Debt and Operating Leases) 134 $781

$206 Rentals – Principal Payments 77 Current Dollar

Income E: Capitalize Expenses (-) Advertising and R & D After Tax (0) Gross Cash Flow

Assets Total Assets $5,825 Current Dollar

$5,825 A: Eliminate Non-Operating (-) Non-Operating Assets (137) Investor Gross

Items (-) Purchase Goodwill (1,531) Cash

Receivables Reserve 23 Investment

B: Translate to Cash Invest. LIFO Reserve 141 $5,704

Accumulated Depreciation 1,580

C: Restate for Inflation Inflation Adjustments to Land, Gross Plant and Deferred Taxes 249

D: Eliminate Leverage Gross Leased Property from Operating Leases 1,202

E: Capitalize Expenses Capitalized Advertising, R & D 0

F: Capital Owner Cash Invest. (-) Operating Non-Interest Bearing Liabilities (1,648)

CASH ECONOMIC RETURN EXAMPLE:CASH ECONOMIC RETURN EXAMPLE:ACCOUNTING TO CASHACCOUNTING TO CASH

SUPERVALU– 2001 ($Millions)SUPERVALU– 2001 ($Millions)

Page 28: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 28 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

CASH ECONOMIC RETURN EXAMPLE:CASH ECONOMIC RETURN EXAMPLE:CASH TO ECONOMICSCASH TO ECONOMICS SUPERVALU– 2001 ($ MILLIONS)SUPERVALU– 2001 ($ MILLIONS)

Current Dollar Gross Cash Flow

$781Non-Depreciating

Asset Release

$727

($5,704)

Current Dollar Investor Gross

Cash Investment

Economic Life: 11.55 Years

Cash Economic Return - IRR: 9.09% Years IRR

11 8.62

12 9.48

11.55 9.09

Page 29: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 29 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

CASH ECONOMIC RETURN REFLECTS THE CASH ECONOMIC RETURN REFLECTS THE AVERAGE INTERNAL RATE OF RETURN OF AVERAGE INTERNAL RATE OF RETURN OF

ALL THE PROJECTS IN PLACEALL THE PROJECTS IN PLACE

Cash Economic Return

Existing Projects

Page 30: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 30 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

0

5

10

15

20

25

0 1 2 3 4 5 6 7 8 9 10

Year

Ca

sh

Ec

on

om

ic R

etu

rn

LIFE CYCLE OF CASH ECONOMIC RETURNS (CER)LIFE CYCLE OF CASH ECONOMIC RETURNS (CER)

Firm Fading CER*

CER Momentum Effect

Firm CER Fade-To

Super Sector CER Fade-ToFirm CER Fade-To Difference

Firm Discount Rate, Adjusted for Leverage, Asset Mix, and Asset Life

Cash Flows continue for 50 Years =>

Super SectorsIndustrials

UtilitiesFinancials

(*Real ROE)

Page 31: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 31 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

CASH ECONOMIC RETURNS FADE (REGRESS) CASH ECONOMIC RETURNS FADE (REGRESS) TOWARD THE MEAN, BUT NOT ALL THE WAYTOWARD THE MEAN, BUT NOT ALL THE WAY

THE 10THE 10THTH DECILE FADES DOWN, BUT NOT ALL THE WAY; DECILE FADES DOWN, BUT NOT ALL THE WAY; THE 1THE 1STST DECILE FADES UP, BUT NOT ALL THE WAY DECILE FADES UP, BUT NOT ALL THE WAY

-10-505

10152025303540

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Year

Ca

sh

Ec

on

om

ic R

etu

rn 1st2nd3rd4th5th6th7th8th9th10th

Median of Each DecileNote: Competitive Pressure Forces High

Returns Down; Investor and Debt Pressure ForcesLow Returns Up; Most All the Fade Occurs in 5 Years

1994-1999

Industrials Constant Dollar Gross Investment > $100 Million in 1994, N = 1,267

Page 32: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 32 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

LCRT’S RESEARCH METHODOLOGY CONTRASTS LCRT’S RESEARCH METHODOLOGY CONTRASTS SHARPLY WITH THE TRADITIONAL VALUATION SHARPLY WITH THE TRADITIONAL VALUATION

APPROACHAPPROACH

Traditional Approach Forecasts 3-10 Years of Cash

Flows Applies Perpetuity or Multiple

for Terminal Value Discounts to Present (“plan

valuation”) Implicitly assumes the

structure and parameters of the terminal valuation are robust and accurate or “plugs” the parameters to explain current price

Fails to measure model risk (e.g. Susan Mangiero)

LCRT Methodology Employs only actual data to

empirically test robustness and accuracy of “spot intrinsic valuation” models and parameters

Extends the best models to use as terminal values in traditional “plan intrinsic valuations”

May eventually test the best models with forecast security analyst data

Page 33: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 33 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

EMPIRICAL EMPIRICAL DIFFERENCES DIFFERENCES

BETWEEN MODELSBETWEEN MODELS

Page 34: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 34 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

EMPIRICAL EVIDENCE:EMPIRICAL EVIDENCE: LCRT’s MODEL IS 28-67% MORE ACCURATE THAN LCRT’s MODEL IS 28-67% MORE ACCURATE THAN

OTHER MODELS (at 50OTHER MODELS (at 50thth Percentile) Percentile)

LOG2 of % Absolute Model Error versus Actual Price -

Fiscal Year +3 Months 1994-200247 63 79

67

Cumulative % of Universe

Sources:Financial Statements and Price Data – CapitalIQCalculations - LCRT’s PlatformConstant Dollar Gross Investment > $100 Million20,957 Company-Years; 1994-2002; Industrials

Sources:Financial Statements and Price Data – CapitalIQCalculations - LCRT’s PlatformConstant Dollar Gross Investment > $100 Million, Panel Data from 1994-2002, 17,697 Company-Years

Page 35: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 35 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

FREE CASH FLOW AND LCRT INTRINSIC VALUES FREE CASH FLOW AND LCRT INTRINSIC VALUES PERFORM THE BEST TO SEPARATE “WINNERS” FROM PERFORM THE BEST TO SEPARATE “WINNERS” FROM

“LOSERS”“LOSERS”

Sources:Financial Statements and Price Data – CapitalIQCalculations - LCRT’s PlatformConstant Dollar Gross Investment > $100 Million20,957 Company-Years; 1994-2002; Industrials

Sources:Financial Statements and Price Data – CapitalIQCalculations - LCRT’s PlatformConstant Dollar Gross Investment > $100 Million, Panel Data from 1994-2002, 17,697 Company-Years

Page 36: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 36 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

ADVANCED LCRT ADVANCED LCRT RESEARCHRESEARCH

Page 37: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 37 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

UNDER (OVER) INTRINSIC VALUATION VERSUS UNDER (OVER) INTRINSIC VALUATION VERSUS CER ILLUSTRATES EMPIRICAL VALUE AUDIT CER ILLUSTRATES EMPIRICAL VALUE AUDIT

ANALYSIS OF OUTLIERS AND PATTERNSANALYSIS OF OUTLIERS AND PATTERNSCER Fade-To

N = 26,018, 1994-2003Industrials, C$GI > $100M

R2 = 0.341

MSFT, Yahoo

AAPL, GY,AMESQ

Page 38: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 38 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

NEXT GENERATION LCRT MODELNEXT GENERATION LCRT MODEL Place all risk and other effects in the cash flows, so a singlesingle discount rate

applies to ALLALL firms in each super sector for each year (22,000-115,000+ company-years 1994-2003)

Treat equity as an option on the cash economic returns, growth, capital structure, and restructuring potential of the operating assets (using only disclosed historical data to drive the model’s cash flow forecast)

– Refine company CER Fade-To’s and Fade Rates to reflect empirical realities across the entire CER spectrum from boundary to boundary, using option functions; use a put function for start-up CER Fade-to’s

– Refine asset growth fade rates to reflect market expectations– Employ an option pricing function to quantify the deadweight loss of

bankruptcy and a [0,1] function to describe the loss in intrinsic value of the equity put for any debt

– Use a call option to describe the market expected increase in cash flows due to restructuring from excessive debt overhang (the Michael Jensen effect)

– Divide the intrinsic value employing one uniform discount rate for all firms into its debt and equity components

Page 39: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 39 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

CONCEPUTAL COMPARISON OF CONCEPUTAL COMPARISON OF THREE LCRT MODELSTHREE LCRT MODELS

LCRT Research– Place all risk and other effects in the cash flows, so a singlesingle discount

rate applies to ALLALL firms in each super sector for each year (27,000 company-years 1994-2003)

– Treat equity as an option on the cash economic returns, growth, capital structure, and restructuring potential of the operating assets (using only disclosed historical data to drive the model’s cash flow forecast)

LCRT DCF– No option pricing functions– Fade CER’s to 35% of difference between current level and median for

universe– Discount rate adjusted for leverage, asset mix, and asset life

LCRT Without Enhancements– Fade CER’s to median for universe– Discount rate adjusted for leverage

Page 40: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 40 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

ACROSS THE UNIVERSE OF ABOUT 30,000 COMPANY-ACROSS THE UNIVERSE OF ABOUT 30,000 COMPANY-YEARS 1994-2003, THE MEDIAN ACCURACY OF LCRT’S 2YEARS 1994-2003, THE MEDIAN ACCURACY OF LCRT’S 2NDND

GENERATION MODEL (RESEARCH) IS APPROXIMATELY 27% GENERATION MODEL (RESEARCH) IS APPROXIMATELY 27% GREATER THAN OTHER MODELS (BUT NOT GREATER THAN OTHER MODELS (BUT NOT

OVERWHELMING)OVERWHELMING)

LOG2 of % Absolute Model Error Versus Actual Price -

Fiscal Year +3 Months 1994-2003

Cumulative % of Universe

Sources:Financial Statements and Price Data – CoreDataCalculations - LCRT’s Platform29,488 Company-Years; 1994-2003; Non-Financials

•All Models derived from purely historical data without analyst intervention

•Note the simple 8 X EBITDA valuation is more accurate up to 30% of the Universe compared to Residual income, Feltham-Ohlson, and Free Cash Flow Perpetuity – No wonder security analysts and portfolio managers employ simple multiples

Page 41: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 41 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

CASH ECONOMIC RETURN FADE TO’S RELY ON CASH ECONOMIC RETURN FADE TO’S RELY ON SMALL FIRM PUT, LARGE FIRM CALL, AND SMALL FIRM PUT, LARGE FIRM CALL, AND

MEDIUM SIZE STRADDLE FUNCTIONSMEDIUM SIZE STRADDLE FUNCTIONS

0102030405060708090

100

-100 -50 0 50 100 150 200

Beginning Cash Economic Return (CER)

Ca

sh

Ec

on

om

ic R

etu

rn F

ad

e-T

o

Large

Medium

Small

Small Start-Up

Firms

Large Monopoly Firms

Page 42: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 42 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

CASH ECONOMIC RETURN FADE RATES RELY ON CASH ECONOMIC RETURN FADE RATES RELY ON PUT FUNCTIONSPUT FUNCTIONS

0102030405060708090

100

-100 -50 0 50 100 150 200

Beginning Cash Economic Return (CER)

Ca

sh

Ec

on

om

ic R

etu

rn F

ad

e R

ate

s

Small

Medium

Large

Small Firms Fade Faster than Large Firms

Page 43: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 43 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

LCRT PLACES LEVERAGE RELATED RISK IN THE CASH LCRT PLACES LEVERAGE RELATED RISK IN THE CASH FLOWS INSTEAD OF THE DISCOUNT RATE IN ORDER TO FLOWS INSTEAD OF THE DISCOUNT RATE IN ORDER TO EMPLOY A UNIFORM DISCOUNT RATE FOR ALL FIRMS IN EMPLOY A UNIFORM DISCOUNT RATE FOR ALL FIRMS IN

THE SUPER SECTOR EACH YEARTHE SUPER SECTOR EACH YEAR

0

10

20

30

40

50

60

0 25 50 75 100 125 150

% Debt to Debt Capacity (PV of Cash Flows from Existing Assets)

% L

os

s o

f In

trin

sic

Va

lue

Small

Medium

Large

Deadweight Bankruptcy Cost of Higher Leverage[0,1] Function

of Equity Put for ANY Debt

Call Functions

Page 44: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 44 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

OUTPUTS AND USAGE OUTPUTS AND USAGE OF LCRT PLATFORM OF LCRT PLATFORM FROM THE USER’S FROM THE USER’S

POINT OF VIEWPOINT OF VIEW

Page 45: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 45 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

LLIFEIFECCYCLEYCLE R RETURNSETURNS P PLATFORMLATFORM“A Conceptually Sound, Empirically Validated, “A Conceptually Sound, Empirically Validated,

Disciplined Methodology for Valuation”Disciplined Methodology for Valuation”

Overview of Concepts– Empirical Evidence (Refer to

www.LCRT.com for more Information)– LCRT Framework: From Accounting to

Cash; From Cash to Economics; from Economics to Valuation

– Cash Economic Return Example: Accounting to Cash

– Cash Economic Return Example: Cash to Economics

– Life Cycle of Cash Economic Returns Retrieve Company by Ticker or Name – 11,000+

Firms; 1994-2003 Compare Valuation Models’ Results Valuation Control Center for most recent Year

(The “Cockpit”)– Company Inputs and Platform

Parameters– Overrides for Sensitivities– Audit Trails– Charts

Charts – Value Chart and Relative Wealth Chart

Overrides for multiple years to reflect analysts’ insights and forecasts into valuations to achieve greater predictive capability

GoTo Reports in Excel Annual Sheet for Complete Audit Trails of Calculations and Analytical Insights

View Audit Trails for LCRT Valuation, Market Derived Discount Rates, and Plant Inflation Adjustments

Personal Sheet for Customized Company Reports, Calculations, and Valuations

Extract Variable List for Future Cross Sectional Analysis

Extract for Cross Sectional Analysis of Multiple Companies and Research

Articles – “Value Management – Past, Present, and Future” (Concepts – 44 pages)

– Economic Performance Measurement– Valuation– Cost of Capital– Applications

Page 46: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 46 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

START THE NUCLEUS; SELECT START THE NUCLEUS; SELECT RETRIEVE COMPANY FROM THE RETRIEVE COMPANY FROM THE

LCRT MENU PULL-DOWNLCRT MENU PULL-DOWN

Page 47: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 47 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

SELECT LCRT … CHARTS … SELECT LCRT … CHARTS … INTRINSIC VALUE CHARTINTRINSIC VALUE CHART

Use the “Intrinsic Value” to determine whether the company is under/over valued. If the red Intrinsic Value “*” for the last year is above the closing price at Fiscal Year + 3 Months, the company is a “buy” candidate. If the “Intrinsic Value” is below the stock price, the opposite would be true.

Use the information in the lower right corner to determine the accuracy of the intrinsic value model. Look for a low “absolute error” and a low “signed error” along with a high “model robustness.” Absolute error measures the geometric mean of the absolute % difference between actual stock price (hollow dots) at Fiscal Year + 3 Months and the intrinsic value. Signed error measures the geometric mean of the % difference between the stock price and the intrinsic value. Model robustness measures the % of years where the model calculates a value.

Page 48: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 48 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

SELECT LCRT … OVERRIDES TO ADD ANALYST SELECT LCRT … OVERRIDES TO ADD ANALYST ESTIMATES AND OTHER ANNUAL OVERIDESESTIMATES AND OTHER ANNUAL OVERIDES

Click on the tab marked “Forecasts” and enter values for the “current fiscal year forecast” and the “next fiscal year forecast“ for both sales and EPS. When completed, either click on one of the chart buttons at the bottom of the window or “Save – Exit” to return to the worksheet where your estimates appear. Note, the Nucleus stores the values entered for the next time you retrieve the particular company. Now when you view the “value chart”, the chart displays the forecasts. LCRT has programmed customized processes to include computer readable estimates from the client’s First Call, I/B/E/S, Stock/Val, Value Line or internal sources.

Page 49: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 49 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

THE VALUE CHART NOW INCORPORATES THE VALUE CHART NOW INCORPORATES ANALYST ESTIMATESANALYST ESTIMATES

ASSUMING CONSTANT CAPITAL TURNOVER AND NON-EARNINGS MARGINASSUMING CONSTANT CAPITAL TURNOVER AND NON-EARNINGS MARGIN

Page 50: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 50 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

THE VALUE CHART COMPARES MULTIPLE THE VALUE CHART COMPARES MULTIPLE MODELS AND THEIR ACCURACYMODELS AND THEIR ACCURACY

The Absolute “Tracking” Error Intrinsic Value vs. Actual Equals the Absolute Geometric Mean Error

Between The Intrinsic Value Red Line And Closing Prices at Fiscal Year + 3 Months

(hollow circles) Over the Number of Years

LCRT

Residual Income

LCRT15.2

Residual Income65.2

Page 51: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 51 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

FOR HEWLETT-PACKARD, A FREE CASH FLOW MODEL FOR HEWLETT-PACKARD, A FREE CASH FLOW MODEL DISPLAYS LOWER ACCURACY THAN LCRTDISPLAYS LOWER ACCURACY THAN LCRT

(OF COURSE, HP IS ONLY A SAMPLE OF ONE)(OF COURSE, HP IS ONLY A SAMPLE OF ONE)

LCRTFree Cash Flow

LCRT15.2

Free Cash Flow23.5

Absolute “Tracking” Error

Page 52: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 52 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

THE COMPARATIVE INTRINSIC VALUE THE COMPARATIVE INTRINSIC VALUE CHART ALSO QUANTIFIES VALUE EFFECTS CHART ALSO QUANTIFIES VALUE EFFECTS

OF NON-RECURRING ITEMS WHICH MAY OF NON-RECURRING ITEMS WHICH MAY NOT BE ONE TIME EVENTSNOT BE ONE TIME EVENTS

Page 53: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 53 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

COMPANY RELATIVE WEALTH COMPANY RELATIVE WEALTH CHARTCHART

The Relative Wealth Chart provides a strategic overview of the company’s investment policy and results. The first panel on this chart identifies the trend of the company’s Cash Economic Return (CER) Look for positive trends to identify companies that are “buy/hold” candidates.

The second panel shows the “asset growth” for the company. For firms after their start-up period, companies with positive spreads of CER over the discount rate create shareholder value by growing their assets, while companies with negative spreads destroy shareholder value.

The third panel show the “relative wealth” of the company compared to the S&P 500.

Page 54: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 54 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

Valuation Compliment:Valuation Compliment:Use the Valuation Control Center to test the sensitivity of company Use the Valuation Control Center to test the sensitivity of company

values to changing company inputs and Platform parameters.values to changing company inputs and Platform parameters.Click on the “LCRT” menu and choose “Valuation Control Center…”/Click on the “LCRT” menu and choose “Valuation Control Center…”/

Change any of the numbers in the “Override” column to see the impact at the bottom of the window and the effect on the charts displayed on the right side.

Notice the additional charts with tabs above the Value Chart.

Also view the “standard” value chart by clicking the “View Standard” button.

Use the “Save Overrides” button to save the overrides to re-display when viewing this company.

The display of an “audit trail” represents one of the strongest features of the LCRT Nucleus to show precisely the determination of the present value of cash flow results. Click on “view base audit trail” or “view override audit trail” to display all the calculations used to determine the results shown at the bottom of this window.

Page 55: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 55 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

The display of an “audit trail” represents one of the strongest The display of an “audit trail” represents one of the strongest features of the LCRT Nucleus to show precisely the determination of features of the LCRT Nucleus to show precisely the determination of

the present value of cash flow results. Click on “view base audit the present value of cash flow results. Click on “view base audit trail” or “view override audit trail” to display all the calculations used trail” or “view override audit trail” to display all the calculations used

to determine the results shown at the bottom of this window.to determine the results shown at the bottom of this window.

Although CSFB explains calculations, HOLT does not provide full transparent audit trails in Excel or VB for every single calculation, every year, and every company! (FORTRAN precludes this.)

Page 56: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 56 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

Finding a Report: The powerful Nucleus worksheet contains hundreds of reports and analyses of Finding a Report: The powerful Nucleus worksheet contains hundreds of reports and analyses of each company. To ease navigation, a “Go to” feature assists in locating and moving to a report in each company. To ease navigation, a “Go to” feature assists in locating and moving to a report in the worksheet. Click on the “LCRT” menu and choose “GoTo Report…”. A window appears the worksheet. Click on the “LCRT” menu and choose “GoTo Report…”. A window appears containing either a list of all the reports or a tree structure allowing you to locate the particular containing either a list of all the reports or a tree structure allowing you to locate the particular report. For this explanation, use the “Tree” structure. If the “Tree View” is not displayed, click on report. For this explanation, use the “Tree” structure. If the “Tree View” is not displayed, click on the tab marked “Tree View”.the tab marked “Tree View”.

Page 57: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 57 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

Locate the “Comparison of Models Intrinsic Values Locate the “Comparison of Models Intrinsic Values Chart” and either double-click on the name or click Chart” and either double-click on the name or click

once and then click on the “Go” button at the once and then click on the “Go” button at the bottom of the window.bottom of the window.

Page 58: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 58 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

This particular report compares the valuations and tracking errors of all the models in This particular report compares the valuations and tracking errors of all the models in the LCRT Nucleus. The ability to “trace” the source for all calculations represents one the LCRT Nucleus. The ability to “trace” the source for all calculations represents one

of the prime benefits of using Excel as the base for the LCRT Nucleus. To use this of the prime benefits of using Excel as the base for the LCRT Nucleus. To use this feature, move to the cell in question and click on “Tools”, “Formula Auditing” and feature, move to the cell in question and click on “Tools”, “Formula Auditing” and

“Trace Precedents”. Follow the lines up to the source of the values for the particular “Trace Precedents”. Follow the lines up to the source of the values for the particular cell.cell.

Page 59: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 59 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

ADJUSTING USER LEVELADJUSTING USER LEVEL To display additional or less

detail for a company, modify your “level” by clicking on the “LCRT” menu and then clicking on “User Display Level”.

Choose the appropriate level of detail and then click “Set level”. This may take a few minutes to display the rows in the worksheet associated with the level you select. The Platform remembers your choice the next time you reference the worksheet.

Page 60: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 60 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

TO INDENTIFY A VARIABLE FOR CROSS TO INDENTIFY A VARIABLE FOR CROSS SECTIONAL ANALYSIS OR SCREENING, SELECT SECTIONAL ANALYSIS OR SCREENING, SELECT

LCRT … EXTRACT VARIABLE LIST ADDLCRT … EXTRACT VARIABLE LIST ADD

Page 61: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 61 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

TO SCREEN, ANALYZE OR RESEARCH TO SCREEN, ANALYZE OR RESEARCH VARIABLES, BEGIN LCRT EXTRACT; RESULTS VARIABLES, BEGIN LCRT EXTRACT; RESULTS

EXTRACT TO EXCEL OR SPSSEXTRACT TO EXCEL OR SPSS

Page 62: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 62 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

NARROW SEARCH WITH NARROW SEARCH WITH SECTORS OR INDUSTRIESSECTORS OR INDUSTRIES

Page 63: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 63 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

EXTRACT RESULTS TO EXCEL FOR ANALYZING EXTRACT RESULTS TO EXCEL FOR ANALYZING OR SPSS FOR ADVANCED RESEARCH INTO OR SPSS FOR ADVANCED RESEARCH INTO

SYSTEMATIC STRUCTURAL ERRORS OF MODELSSYSTEMATIC STRUCTURAL ERRORS OF MODELS(MODEL RISK – SUSAN MANGIERO)(MODEL RISK – SUSAN MANGIERO)

CER Fade-To

N = 26,018, 1994-2003Industrials, C$GI > $100M

R2 = 0.341

MSFT, Yahoo

AAPL, GY,AMESQ

Page 64: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 64 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

THE PERSONAL SHEET WITHIN THE NUCLEUS THE PERSONAL SHEET WITHIN THE NUCLEUS ENABLES EXTENSIVE CUSTOMIZATIONENABLES EXTENSIVE CUSTOMIZATION

Free-form creation of Excel valuation models, user derivative property, and empirical testing

Easily references any LCRT variable or function

Ideal for valuing security analysts’ forecasts, company strategic plans or firm business units

Page 65: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 65 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

DATA STRUCTURE AND LINKAGESDATA STRUCTURE AND LINKAGESVendor Database of Fundamental Data, Prices, & Dividends

LCRT NUCLEUS

Universal Chart of Accounts

All Calculations

Decision Tool, Production Engine, Research

Platform

LCRT Save Databases

LCRT EXTRACT

Screening, Advanced Research

Universal Chart of Accounts Accepts Data from Compustat, Simplystocks, CoreData, Value Line, ModelWare, World’Vest, and World Scope

Analyst Estimates for Sales and EPS come from manual input or client sources – Stock/Val, First Call, Zacks, or Value Line

Page 66: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 66 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

BACKUP SLIDESBACKUP SLIDES

Page 67: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 67 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

USING THE LCRT DCF MODEL, 57% OF THE USING THE LCRT DCF MODEL, 57% OF THE APPROVED LIST IS OVER-VALUED AND 72% (100-APPROVED LIST IS OVER-VALUED AND 72% (100-28) IS MORE OVER-VALUED THAN THE UNIVERSE28) IS MORE OVER-VALUED THAN THE UNIVERSE

Any one of the following three hypotheses could be true:

– 1. Approved List may pick more “losers” than “winners”

– 2. OR Approved List may pick more “winners” than “losers”

– 3. OR Employing both the Approved List and LCRT’s valuation may pick more “winners” than “losers”

Empirical Tests to distinguish which Hypothesis of the three is most true

– Translate each dimension of the beliefs used to produce the Approved List into testable valuation models

– Back test each model’s accuracy and predictive capability

– Test combination of Approved List implicit valuation models and LCRT

Feedback from the empirical results will improve the stock selection PROCESS

Approved List

Universe

Median N Approved List -11.3 84Universe -6.2 1,000

57

28 = 100 – 72

Page 68: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 68 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

DIFFERENCES BETWEEN DIFFERENCES BETWEEN CSFB HOLT AND LCRT (1)CSFB HOLT AND LCRT (1)

CSFB HOLT

– Explanation of Calculations; opaque black box

– Modest Accuracy and Predictive Capability

– No Empirical Comparisons to Traditional Models

LCRT

– Full Audit Trail in Excel and VB of Every Calculation

– Greater Accuracy and Predictive Capability

– Extensive Comparisons of Traditional Models with Academic Collaboration

Page 69: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 69 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

DIFFERENCES BETWEEN DIFFERENCES BETWEEN CSFB HOLT AND LCRT (2)CSFB HOLT AND LCRT (2)

LEAD TO MORE ACCURACY AND PREDICTIVE CAPABILITYLEAD TO MORE ACCURACY AND PREDICTIVE CAPABILITY

CSFB HOLT– IRR CFROI® Fails with

Negative Gross Cash Flows

– CFROI® Fades to Discount Rate

– Model works well for large firms in the 50th to 75th CFROI® Percentile

– 3-Year Centered Median and Deviation Statistic Possess Look Ahead Bias

LCRT– Ratio CER calculates

for start-ups and firms in distress

– Persistency in CER Fade-To Consistent with Data

– Research Model extends from Boundary to Boundary

– Annual CER and FY+3 Mos. Deviation Contain No Look Ahead Bias

Page 70: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 70 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

DIFFERENCES BETWEEN AFG DIFFERENCES BETWEEN AFG AND LCRT (1)AND LCRT (1)

AFG

Economic Margin Fades to Zero

Sustainable Growth Rates

LCRT

CER Fades to Fade-To to reflect Fat Tails and Empirical Realities

Sustainable Growth Rates Winsorized to +/- 20%

Operating Gross Cash Flow - Capital ChargeEconomic Margin =

Gross Invested Capital

Operating Gross Cash Flow - S.F. DepreciationCER =

Gross Invested Capital

Page 71: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 71 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

DIFFERENCES BETWEEN AFG DIFFERENCES BETWEEN AFG AND LCRT (2)AND LCRT (2)

AFG Discount Rate

adjusted for Size and Leverage for Median Firm (CSFB HOLT employs aggregates)

LCRT 1st Generation Model

Discount Adjusted for Leverage and Asset Mix for Median Firm

2nd Generation Model places all the risks in the cash flows so employs one discount rate for all firms each year in the Super Sector

Page 72: - 1 - © 2005 LifeCycle Returns, Inc. All Rights Reserved VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Designed to be Challenging.

- 72 -© 2005 LifeCycle Returns, Inc. All Rights Reserved

Sources: Financial Statements and Price Data – CapitalIQ & CoreData - Calculations – LCRT Platform

A BETTER EXPLANATORY MODEL IS A BETTER EXPLANATORY MODEL IS MORE PREDICTIVEMORE PREDICTIVE

Accuracy: % Explanatory Price Level

1009080706050403020100

Acc

ura

cy:

% P

red

ictiv

e C

ap

ital G

ain

100

90

80

70

60

50

40

30

20

10

0

R2 = 0.473N = 2,752

OLS

Least AbsoluteDeviation

LCRT Intrinsic Value Model

These results support the intuition of HOLT’s clients, who in the late 1980’s said, “I only employ the model for buy/sell decisions when it tracks well.”

“Few strokes separate the best from the worst professional golfers.”

Like golf, lower scores indicate more accuracy.

This chart violates the instantaneously efficient market hypothesis. It represents an “anomaly” consistent with behavioral finance theory.