- 1 - LIfeCycle Returns, Inc. © 2004 All Rights Reserved PREDICTIVE CAPABILITY OF VALUATION MODELS New York City QUAFAFEW By Rawley Thomas, President LifeCycle.

- 1 -LIfeCycle Returns, Inc.

© 2004 All Rights Reserved

PREDICTIVE CAPABILITY OF PREDICTIVE CAPABILITY OF VALUATION MODELSVALUATION MODELS

New York City QUAFAFEW

By Rawley Thomas, President

LifeCycle Returns, Inc.

March 23, 2004

[email protected]

- 2 -

LIfeCycle Returns, Inc.© 2004 All Rights Reserved

Predictive Capability of Models – QUAFAFEW March 23, 2004

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AN INTRINSIC VALUE CHART ENABLES US TO AN INTRINSIC VALUE CHART ENABLES US TO VISUALIZE THE MEASUREMENT OF ROBUSTNESS VISUALIZE THE MEASUREMENT OF ROBUSTNESS AND ACCURACY OF A DCF MODEL PRICE AND ACCURACY OF A DCF MODEL PRICE LEVELLEVEL

USING 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

Sources:Financial Statements and Price Data – SimplystocksCalculations - LCRT’s Platform

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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

LCRT Methodology Employs only actual data to

empirically test robustness and accuracy of valuation models, methodologies, and parameters

– Enables testing hypotheses in an independent way which does not contain a look-ahead bias by knowing current price

Extends the best models to use as terminal values in traditional plan valuations using security analyst estimates or other forecasts

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LCRT’s MODEL IS 28-67% MORE ACCURATE LCRT’s MODEL IS 28-67% MORE ACCURATE THAN OTHER MODELS (at 50THAN OTHER MODELS (at 50thth Percentile) AND Percentile) AND MORE ACCURATE FOR 67% OF THE UNIVERSEMORE ACCURATE FOR 67% OF THE UNIVERSE

0 10 20 30 40 50 60 70 80

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

Feltham-Ohlson: 67%=100% (79.2/47.4-1)

Free Cash Flow 38% = 100% (65.7/47.4-1)

8 X EBITDA 28% = 100% (61.0/47.4-1)

Residual Income 33% = 100% (63.4/47.4)

LOG2 of % Absolute Model Error versus

Actual Price - Fiscal Year +3 Months 1994-200247 63 79

67

% Greater Accuracy of LCRT Model at Cumulative 50th Percentile of Universe

Cumulative % of Universe

Tracking error equals the % absolute difference between the Model Intrinsic Value and the actual stock price at Fiscal Year + 3 Months. The Chart compares models, methodologies, or parameters.

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Robustness: % of 20,957 Company-Years Covered 1994-2002

75.28

96.89

99.49

99.95

99.95

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

LCRT’S MODEL IS UP TO 25% MORE LCRT’S MODEL IS UP TO 25% MORE ROBUST THAN OTHER MODELSROBUST THAN OTHER MODELS

LCRT

8 X EBITDA

Residual Income

Free Cash Flow Perpetuity

Feltham-Ohlson

Sources:Financial Statements and Price Data – SimplystocksCalculations - LCRT’s PlatformConstant Dollar Gross Investment > $100 Million

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~ 3,000 INDUSTRIAL AND MANUFACTURING COMPANIES WITH ~ 3,000 INDUSTRIAL AND MANUFACTURING COMPANIES WITH MEDIAN TOTAL SHAREHOLDER RETURN OF -7.84% 1994-2002 MEDIAN TOTAL SHAREHOLDER RETURN OF -7.84% 1994-2002

DIVIDED INTO “WINNERS” AND “LOSERS” BASED ON DIVIDED INTO “WINNERS” AND “LOSERS” BASED ON INTRINSIC VALUE SCREENS AT FISCAL YEAR + 3 MONTHS INTRINSIC VALUE SCREENS AT FISCAL YEAR + 3 MONTHS

SPLITTING DISTRIBUTION APPROXIMATELY IN HALFSPLITTING DISTRIBUTION APPROXIMATELY IN HALF


Total UniverseMedian = -7.84%N = 17,697 Company-Years1994-2002 Panel Data

“Winners” are under-valued at Fiscal Year + 3 Months and “Losers” are over-valued at Fiscal Year + 3 Months.

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LCRT “WINNERS” OUT-PERFORM LCRT “WINNERS” OUT-PERFORM “LOSERS” BY 12.3% (= -2.04 –(-14.38))“LOSERS” BY 12.3% (= -2.04 –(-14.38))


“Winners”Median = -2.04%N = 8,628 Company-Years1994-2002 Panel Data

“Losers”Median = -14.38%N = 8,771 Company-Years1994-2002 Panel Data

“Winners” are under-valued at Fiscal Year + 3 Months and “Losers” are over-valued at Fiscal Year + 3 Months.

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

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

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

Relative Wealth Spread: Winners Minus Losers %

-5

0

5

10

15

0 1 2 3 4 5 6 9 12 15 18

Fiscal Month

% S

pre

ad

Free Cash Flow

LCRT

Residual Income

TSR Price Momentum

8 X EBITDA

Feltham-Ohlson


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COMBINING FREE CASH FLOW AND LCRT COMBINING FREE CASH FLOW AND LCRT SCREENS SEPARATE “WINNERS” FROM SCREENS SEPARATE “WINNERS” FROM

“LOSERS” BY 17.0% = (-.45-(-17.50)“LOSERS” BY 17.0% = (-.45-(-17.50)

FCF “Winners” & LCRT “Winners”Median = -0.45%N = 7,074 Company-Years

FCF “Losers” & LCRT “Winners”Median = -7.74%N = 1,527 Company-Years

FCF “Losers” & LCRT “Losers”Median = -17.50%N = 6,320 Company-Years

FCF “Winners” & LCRT “Losers”Median = -7.54%N = 2,212 Company-Years

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

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THE LCRT INTRINSIC VALUE SCREEN THE LCRT INTRINSIC VALUE SCREEN SUCCESSFULLY SEPARATES “WINNERS” SUCCESSFULLY SEPARATES “WINNERS” FROM “LOSERS” FOR ALL YEARS EXCEPT FROM “LOSERS” FOR ALL YEARS EXCEPT

FISCAL YEARS 1997-1998FISCAL YEARS 1997-1998

Recall that Fiscal Years 1997-1998 cover the “Bubble” time period from March of 1998 to March of 2000. The market peaked in August of 2000.


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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.

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BEHAVIORAL EXPLANATIONS OF BEHAVIORAL EXPLANATIONS OF VIOLATIONS OF INSTANTANEOUSLY VIOLATIONS OF INSTANTANEOUSLY EFFICIENT MARKET’S HYPOTHESISEFFICIENT MARKET’S HYPOTHESIS

People employ significantly different and inconsistent models of fundamental valuation, relying on various forecasts

Depending on the weights of all the classes of people buying and selling a stock at any point in time, the actual price will diverge significantly from the long term intrinsic value

Strongly held academic beliefs in instantaneous market efficiency impede empirical research to show otherwise

Price event studies only demonstrate that the market reacts in the correct direction, but not necessarily by the correct amount

Robust, accurate DCF models of intrinsic valuation are required to empirically test instantaneous market efficiency

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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

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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.

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LCRT’S UNIQUE RESEARCH METHODOLOGY LCRT’S UNIQUE RESEARCH METHODOLOGY AND PROCESS CONSULTINGAND PROCESS CONSULTING

Translates each dimension of a person’s belief structure into a testable hypothesis and model

– Relies only on historical data for forecast estimates– Produces an intrinsic value for every company for every year at Fiscal Year + 3 Months to

reflect disclosure lags and prevent look ahead bias– Displays tracking errors on a single chart where tracking errors = % absolute difference

between the intrinsic model value and actual price for all 20,000+ company-years

Measures the predictive capability of the % difference between intrinsic value and actual price for every company for every year for Months Fiscal Year +4, 5, 6, 9, 12, & 15

– Measures the risk of the distributions of “Winners” and “Losers” using the parameters of the fat tailed Stable Paretian Distribution

Determines which models, methodologies, and parameters:– Produce the most accurate intrinsic values with the least tracking errors– Separate the universe into “Winners” and “Losers” with the greatest spread on relative wealth

performance from Fiscal Year +3 Months to +15 Months

Changes valuations, investment processes, and cultures with a powerful Platform by producing comparative quantitative feedback on belief structures of stock market pricing and reactions to fundamentals

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EXTRA SLIDESEXTRA SLIDES

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THE LCRT INTRINSIC VALUE SCREEN THE LCRT INTRINSIC VALUE SCREEN SUCCESSFULLY SEPARATE “WINNERS” FROM SUCCESSFULLY SEPARATE “WINNERS” FROM “LOSERS” FOR ALL YEARS EXCEPT 1997-1998“LOSERS” FOR ALL YEARS EXCEPT 1997-1998


Recall that Fiscal Years 1997-1998 cover the “Bubble” time period from March of 1998 to March of 2000. The market peaked in August of 2000.



COMPARATIVE ACCURACY AND COMPARATIVE ACCURACY AND PREDICTIVE CAPABILITY OF PREDICTIVE CAPABILITY OF LCRT AND FORMER MODELSLCRT AND FORMER MODELS

By

Rawley Thomas

President


February 20, 2004

[email protected]

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LCRT’S RESEARCH MODEL IMPROVES ON FORMER LCRT’S RESEARCH MODEL IMPROVES ON FORMER MODELS WITHOUT ENHANCEMENTS AND OVERRIDES MODELS WITHOUT ENHANCEMENTS AND OVERRIDES

BY 13.7% (=100% (53.9/47.4 -1))BY 13.7% (=100% (53.9/47.4 -1))

Cumulative % of Universe

LOG2 of % Absolute Model Error versus Actual Price –

Fiscal Year + 3 Months 1994-2002

47 54

Sources:Financial Statements and Price Data – SimplystocksCalculations - LCRT’s PlatformConstant Dollar Gross Investment > $100 Million, 1994-2002

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LCRT PERFORMS BETTER THAN FORMER MODELS LCRT PERFORMS BETTER THAN FORMER MODELS WITHOUT ENHANCEMENTS AND OVERRIDES TO WITHOUT ENHANCEMENTS AND OVERRIDES TO

SEPARATE “WINNERS” FROM “LOSERS”SEPARATE “WINNERS” FROM “LOSERS”


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LCRT PERFORMS 2.6% BETTER THAN FORMER LCRT PERFORMS 2.6% BETTER THAN FORMER MODELS WITHOUT ENHANCEMENTS AND OVERRIDES MODELS WITHOUT ENHANCEMENTS AND OVERRIDES

TO SEPARATE “WINNERS” FROM “LOSERS”TO SEPARATE “WINNERS” FROM “LOSERS”

Sources:Financial Statements and Price Data – SimplystocksCalculations - LCRT’s PlatformConstant Dollar Gross Investment > $100 Million, 1994-2002

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COMPARISON OF LCRT RESEARCH AND COMPARISON OF LCRT RESEARCH AND FORMER MODELS WITHOUT FORMER MODELS WITHOUT

ENHANCEMENTS AND OVERRIDESENHANCEMENTS AND OVERRIDES

LCRT RESEARCH CER Fade-To based on 7 Year

Past Median of Firms with Current Dollar Gross Investment > 100 $Million

45% CER Fade Rate, 50% Growth Fade Rate, 40% Sustainability Factor, 10% CER Momentum

Market Derived Discount Rate related to leverage, inventory asset mix, and depreciating asset mix X plant life

Excessive growth rates limited to -15% to +20% by arc-tangent function

FORMER MODELS CER Fade-To based on long term

CER for aggregate of large firms

10% CER Fade Rate, 10% Growth Fade Rate, 0% Sustainability Factor, 0% CER Momentum

Market Derived Discount Rate related to leverage

No limit on excessive growth rates



VALUE MANAGEMENTVALUE MANAGEMENTPAST, PRESENT, & FUTUREPAST, PRESENT, & FUTURE

(A WORK-IN-PROGRESS)(A WORK-IN-PROGRESS)(Excerpts)(Excerpts)

Financial Management Association International

Denver, Colorado

October 9, 2003By

Rawley Thomas

President


[email protected]

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

DECLINING BALANCE CURVE REFLECTING DEPRECIATED PLANTDECLINING 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)

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ECONOMIC VERSUS ACCOUNTING ECONOMIC VERSUS ACCOUNTING ANNUAL PERFORMANCE MEASURESANNUAL PERFORMANCE MEASURES

In order to accurately reflect asset productivity, economic measures should assume constant dollar level annuities of cash flows

In contrast, traditional accounting measures, like RONA (Return On Net Assets), do not reflect the reality of asset utilization. They only reflect the IRR of the underlying project, when the output declines linearly.

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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%

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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

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IMPROVED MEASUREMENTS IMPROVED MEASUREMENTS (PORTFOLIO)(PORTFOLIO) GREATER GREATER INSIGHTSINSIGHTS

SUPERIOR DECISIONS SUPERIOR DECISIONS

Portfolio Applications

Traditional LCRT Framework

CER (Cash Economic Return)

E.P.S. Rising Purchase CER Declining Sell

P/E Low Purchase CER< Cost of Capital and Growing

Sell

E.P.S. Level Avoid CER Rising Buy

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THE LIFE CYCLE OF THE AVERAGE FIRMTHE LIFE CYCLE OF THE AVERAGE FIRM

Time

Gro

ss I

nve

stm

ent

GrowthPhase

Decay fromDrop-Outs Due toAcquisition& Bankruptcy

-50

-40

-30

-20

-10

0

10

20

30

40

50

Time

Cas

h E

con

om

ic R

etu

rn

Investors price for these expectations in Firms’ life cycles and associated cash flows.

Corporate Average

Start-Up

GrowthPhase

SurvivingMatureFirm

Fade

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VALUATION:VALUATION: SIMPLE DISCOUNTED CASH FLOW SIMPLE DISCOUNTED CASH FLOW

PRESENT VALUE PRINCIPLES PRESENT VALUE PRINCIPLES

Since the corporate rate of return of 20% exceeds the investor’s discount rate of 10%, the price of $109 exceeds the $100 cost of the Gross Investment.

Gross Investment

Time 0 Time 1

$100 $100

$120

Value $109 $20 Gross Cash Flow 20% Return

$100 $20 $1091 1.10CashFlowValueDiscountRate

- 1 - LIfeCycle Returns, Inc. © 2004 All Rights Reserved PREDICTIVE CAPABILITY OF VALUATION MODELS New York City QUAFAFEW By Rawley Thomas, President LifeCycle.

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