Portfolio123 Virtual Strategy Design Class By Marc Gerstein

Topic3E–SpecialTopicsinValuation

It’stimetofinishthetopicofvaluation.Havingcoveredpricetoearnings,sales,cashflowandbookvalue,younowhavethetoolstoeffectivelyfactorvaluationintoyourmodels.Thereareothermetricsyoucanuse,forexampleinvolvingEBIT,EV/EBITDA,orpricetootherbalancesheetmeasuresbeyondbookvalue.Theconcepts,however,don’tchange.StartwiththeDDMasatheoreticalfoundationand,usingtheratioswecoveredasexamples,relateyourcustomratiotothetaskofmovingustowardtheidealDDMvaluation.Dothatbygoingbeyondthebasicsortingofratiosandconsider,too,the“allelse”itemsthatimpactwhethertheratiooperatesasonemightexpect.Beforeweleavethistopic,let’slookatwhatmaybestbereferredtoasspecialtopics.Therearetwoofthese:AssetPlays,andDiscountedCashFlow.

AssetPlaysAnassetplayisasituationwhereininvestors,sortof,throwfundamentalsoutthewindowandvaluestocksbasedonwhattheybelieveprivatebuyerswouldpayeitherforthecompanyasawholeorforpartsofit.Withthelatter,thegoalistohavethepartsworthmorethanthewhole:Inotherwords,eachoftwosubsidiariesisassumedtobeworth$100millionforatotalbuyoutvalueof$200millionwhiletheactualmarketcapforthecompanyasawholeisonly$150million.Valuingthesesituations,however,canbeaheadscratcher,notsomuchbecausewedon’tknowhow,intheory,tovaluebusinesses(wedefinitelyknowhowtodothis)butbecausereal-worldappearancessuggestnotingalongtheselinesistakingplace.Whenanalystswriteindetailonthetopic,oftentheyactlikerealestateappraisers;theyvaluebasedonstudyofcomps,valuationofcomparablebusinesses.I’llsimplify:Intruth,thereisn’tadime’sworthofdifferencebetweenvaluingWalMartorvaluingano-earningsassetplay.Inbothcases,itallcomesdowntotheexactsamething:DDM(theDividenddiscountModel–andanylogicalmoreimplementableproxieswemightdevise).Don’tdrawconclusionsfromtherealitythatassetplaysarenotdiscussedinsuchlanguage.Oneofthreethingsishappening.

1. Ontheonehand,privatebuyers(and/orinvestmentbankers)maybedoingDDM-stylevaluationsontheirownforthecompaniesorforindividualsubsidiaries.Successfulbuyoutsdespitepremiumtakeoverpricesinvolvesituationswherethebusinesswas,indeed,worthmoretotheprivatebuyerthantoinvestorsinthepublicmarket.

a. OnewaythiscanhappenisthroughouroldfriendP=V+N,priceequalsvalueplusnoise.Nbecomesirrelevantintheprivatemarket.AndthatcreatesopportunitywhereNisactingasadepressantinthepublicmarkets.(Ifyouworkwiththenoise-valueconceptsdiscussedearlier,you’llseemanyinstancesofnoisewindingupwithanegativenumber.)Therefore,youcantrytoidentifypotentialbuyoutsbymodelingbasedonnoisethatisnegativeorverymodestcoupledwithfundamentalsthatsuggestthestockdeservesbetter(don’tassumenoiseshouldbezero,determine,basedonempiricalefforts,abenchmarklevelofnoise).

2. Aprivatebuyermaybeassessingtheriskcomponentofk(costofcapital)and/org(growth)differentlyfromwhat’sbeingdoneinthepublicmarkets.Sometimes,thisissimplyamatterofopinion.TheStreetthinksacompanycangrow5%peryear.Mr.P(asinPrivate)Equitythinksitcangrow12%peryear.Often,though,thisismorethanasimpledifferenceinestimates.Aprivatebuyermaybelieveincumbentmanagementisnotdoingagoodjobandthatnewstewardshipwillenablethecompanytoreachitspotential.Poorfundamentalperformancerelativetopeerscoupled,perhaps,bylessnoiseinthestockrelativetopeersmaybewaysyoucanbuildmodelsthatfindsuchsituations.

3. Privatebuyersareflat-outwrong.EithertheydidanineffectivejobofDDM-inspiredvaluation.Or,theydidn’tbotherdoingitatall(somethingthathappens,sometimesoften).FromthevantagepointoftheStreet,wefilethisunder“W”for“WhoCares.”Thestreetgottakenoutatapremium,patsitselfontheback,andmovesontootherthings.Buthavingspentsometimemanagingajunkbondmutualfund,I’mquitefamiliarwithassetplaysfromthevantagepointofthebuyer(i.e.whathappensaftertheacquisitionclosesandthebusinessvanishesfromthepublicequitymarkets).Theresultcanlookverydifferentthere.InstancesofinattentiontoDDMordeficientimplementationareplentifulandtheresultsoftenugly.This,bytheway,iswhysharesofcompaniesthatannouncethemselvesasacquirerstendtoexperienceknee-jerkdeclines.TheStreetknowshowoftenprivatebuyersgetsloppyandwhenacompanyinwhichtheyholdsharesannouncesandintentionjointhisnot-so-desirableclub,investorsoftenadoptaguilty-until-proven-innocentstance.Asforus,fromourperspectiveasparticipantsinthepublicmarkets,weofthetake-our-money-and-file-it-under-“W”crowd,modelingisnoteasy.Wecan’tspotthesesituationsthroughfundamentalsbecausetheyaren’tbeingdrivenbyfundamentals.Perhapsthebestwaytomodelforsituationslikethisistoseekoutinstancesofrisingnoiseunsupportedbyfundamentals.Butevenatthat,suchmodelsmayworkbetterasideagenerators(identifyagroupofstocksforfollow-upwithcasebycasestudy)thanasautomatedportfolios.Soeveniftestingsuggestslittlepotentialforamodelbuiltalongtheselines,youmaywanttokeepitforuseasanidera

generator.(There’splentyofbenefityoucangetonPortfolio123separateandapartfromcreatingautomatedportfolios.)

Throughoutthis,onethingisclear.DDMisstillattheheartofeverything(recallthatI’mnottalkingaboutDDMintheliteralsense,sincetheformulaisnotreal-worldusable,butasthecorethatlogicallylinkstothevariousproxieswecananddodevise).Whenwevalueassetplays,we’renotusinganysortofdifferentsecretsauce.Thesauceisthesame.Whatwe’remodelingforisdysfunctioninitsapplication;dysfunctiononthepartofpublicmarketassessment,dysfunctiononthepartofincumbentmanagementthatisnotrealizingthecompany’spotential,ordysfunctiononthepartoftheprivatebuyerwho,afterwatchinguswaltzoffhappilywiththepremiumswepocketed,embarksonaslowboattobankruptcy.

DiscountedCashFlow(DCF)ThisistheHolyGrailofsecurities-analysiseducation.It’salsothemostcynicaltrickananalystcanpullonnaïveandunsuspectingclientswhentheytrumpettheirwonderfuldetailedDCFmodels.

• Ontheonehand,DCFmakesthemlookgood,incrediblydiligent.Afterall,DDMis,anexampleofdiscountedcashflow(using,literally,cashflowsinsteadofdividends).Ifwe’retorespectDDM,asweshouldgivenitstheoreticalstature,howmuchmoredeservingofrespectismodelthateschewstheback-of-the-envelopesimplicityofD,kandgandplungesinsteadintothemulti-year(sometimes10ormoreyears)forecastsofcompanyfundamentals.

• Ontheotherhand,inpractice,themodelsaregarbage,complete,totaland

appallinggarbage,somuchsothatIthinkofDCFas“DiscountedCashFluff.”

Weseeeverydayhowharditistoforecastonequarterahead.Sohowseriouslyshouldwetakethedetailedmulti-yearforecaststhatmakeupthebulkoftheseDCFmodels.What’sworseisthequestionofhowwecopewithuncertaintyastoholdingperiod.HowmanyyearsshouldweforecastforaproperDCFexercise?Threeyears?Fiveyears?Tenyears?Fiftyyears?Actually,aswithplainoldDCF,theansweris:infinity.That,ofcourse,isnotdonesinceanalystreportsareformattedonthebasisofthepre-electronic8.5”by11”sheetsofpaper;eveninlandscapemode,it’shardtoshowmuchbeyond10-15years,soinfinityisoutofthequestion.Whathastoanddoeshappenisthatthelastyearculminatesinwhatisknownasaterminalvaluewhichintermsofpracticality,isprettymuchalongthelinesoftheDDM’sincalculable-in-the-real-worldk–gdenominator.

Soasun-implementableasDDMis,DCFisworse.DDMappliesaterminalvaluationtosomethingwecanseerighthereandnow,adividend.DCFappliesasimilarterminalvaluationtoameasureofcashflowassumedforXnumberofyearsintothefuturethatwasderivedseatofthepantsorfrommanyinterimassumptionsallofwhicharenolessvagueandoftenmorevaguethanthequarterlyestimateswecanneverseemtogetrightuntilcompaniesissuefinalguidanceasthequarterapproachesitsend.AndwhenIsayalotofassumptions,ImeanALOT.ADCFspreadsheetIcreatedinconnectionwithanotherprojectrequiredmorethan200inputs!Butwait.Itgetsworse.Thoseterminalvaluationsarenoticingonthecake.TheyaretheheartandsouloftheDCFvaluation.IfyouevergetyouhandsonaDCFmodel,calculateonyourownassumedterminalvalueasapercentoftotalvalue.You’llbeshockedathowhighitis;rarelyifeverbelow50%andoftenmuchhigher.AChangeofPaceNowthatI’verantedandpossiblyriledyoutothepointwhereyou’rereadytohurlallsortsofobsceneinvectivesatanywhopublishDCFmodels,I’mgoingtoswitchgearsand–holdonhere–offeryouaDCFmodel,betterstill,aDCFmodelyoucanuseinPortfolio123.Here’sthecatch:It’snotaconventionalDCFmodelbutanadaptationdesignedtorelyonasfewinputsaspossiblewithmostofthembeingfromhistoricaldata.We’llbeusingwhat’sknownastheResidualIncomeModelandineffect,valuingstocksonthebasisofdiscountedfutureresidualincome.Asisnecessaryforanyexerciseofthisnature,wetowillneedaterminalvalueandittoowillloomlargeinourfinalvaluations.Butunlikeconventionalterminalvalues,oursarebuiltonasolidfoundation(themuchmoreforecast-ablefutureresidualincomeitem),willnotneedtogooutveryfar(eventhreeyearscanbeample)andratherthanassumingperpetualgrowthtoinfinity,itassumeszerogrowthaftertheforecasthorizon(thusbuildingintheoftencravedoftenextolledmarginofsafetyorcushionforerror).TheResidualIncomeModel(RIM)RIM,alsoreferredtointheliteratureastheEdwards-Bell-Ohlson(EBO)valuationtechnique,startswiththefollowingframework:Eq.1 V=C+PVEW Where,V=Value C=Capital PVEW=PresentValueofEnhancementstoWealthAlthoughthisappearstodifferfromDDM,it’sactuallyaclosefirstcousin.Bothmodelsworkwiththepresentvalueoffutureexpectedshareholderwealth.

• DDMmeasureswealththatflowsdirectlyintotheshareholder’shand,

dividends.RIMmeasureswealththatflowstothecorporation,andpresumes,aswedowithvaluationbasedonearnings,salesorcashflow,thatsuchstreamsofwealthcan,intheworkadayworld,serveasreasonableproxiesforwealththatflowsdirectlytoshareholders.

• DDMstartswithabaseofzeroandusesthepresentvalueoffutureexpectedwealthas100%ofitsvaluation.RIMworkswithaknownstartingpoint,abaseofexistingcapitalandlayersthepresentvalueofexpectedadditionsontopofthat.

Movingon,RIMassumesthatthemeasureofstartingcapitalisthecompany’sBookValue.Thatmeanswestartwiththenotionthatthevalueofastockisitsbookvaluepershare.Therefore,assumingnoimpactfromNoise,differencesbetweenobservedPricepershareandobservedBookValuepersharereflectWallStreet’sdollars-and-centsassessmentofcompanyactivitiesthatenhanceordiminishfuturewealth.ThehigherthePBratio,thegreatertheexpectationre:futurewealthenhancement(thisconceptshouldhaveaveryfamiliarringbasedonourconsiderationofPB).SowhatdoesitmeanwhenweseestocksthattradeapartfromthisRIMvaluation?Wecansayit’snoisethatarisesbecause(i)investorsarepayingtoomuchortoolittleforthewealthenhancementordestructionthatislikelytooccur,and/or(ii)investorsmisjudginglikelywealthcreation/destruction.Movingnow,towardanimplementablemodel,we’llchangeCinEquation1toBY:Eq.2 V=BV+PVEW Where,V=Value BV=BookValue PVEW=PresentValueofEnhancementstoWealthPVEW,thegoodstuff,startswiththebasicmeasureofcorporateprowess;ROE,returnonequity.ButROEalonedoesnottelluswhetherthecompanyisenhancingordestroyingwealth.Acompanywhosecostofequityis6%percentwouldbecreatingwealthifitcanusethatequitytogeneratean8%return.Ontheotheracompanythatpays12%forequitycapitalbutearnsonly10%isdestroyingwealth.SoratherthanworkingwithrawROE,we’llmeasurewealthcreationintermsofexcess,or“abnormal,”ROE.Eq.3 AROE=ROE-CE Where,AROE=Abnormalreturnonequity ROE=Returnonequity

CE=CostofEquityHavingbroughtROEintoaprominentpositioninourmodel,let’srefreshourselvesabitonwhatweknow.Eq.4 ROE=NI/BV Where,NI=NetIncome ROE=Returnonequity BV=Bookvalue(orequity)Applyingsomesimplerearranging:Eq.5 NI=ROE*BVThatwasanimportantdetour.ApplyingthelogicofEquation5,wecansaythatResidualIncome,theportionofnetincomethatenhanceswealth,is:Eq.6 RI=AROE*BV Where,RI=ResidualIncome AROE=AbnormalReturnonequity BV=Bookvalue(orequity)SubstitutingforAOREusingitscomponents,wehavethis:Eq.7 RI=(ROE–CE)*BV Where,RI=ResidualIncome ROE=Returnonequity CE=CostofEquity BV=Bookvalue(orequity)Let’snowapplytheseconceptstoourvaluationframework;priceequalscapitalplusthepresentvalueofwealth-enhancingactivities.Eq.8 V=C+PVEW V=BV+PVfutureRI V=BV+PVfuture(ROE-CE)*BVStatedmoreformally: ∞Eq.9 Vt=BVt+Σ[(ROEt–CE)BVt]/(1+CE)t t=1 Where,V=Value

BV=BookValue RI=Residualincome ROE=Returnonequity CE=CostofEquityEquation9istheresidualincomemodel.Admittedly,atfirstglance,thismaylookeverybitasintimidatingasDDMorDCF.HowonearthamIgoingtoestimateROEforeveryoneofwho-knows-how-manyyears!Here’sthedifference:ROEisprobablythesinglemostsubstantialandpersistentmetricwehaveinourarsenal.IfyouwanttomoveonquicklywithRIM,youcantakemywordforthis,fornow,untilwecoveritwhenwegettoQuality(thenextTopic).Ifyoudon’twanttowait,youcancheckmypostingintheparallelon-lineseminarI’mdoingforSmartAlphasubscribers,whereinIalreadypostedtheQualitytopic,whichyoucanget,asaPDF,here:https://drive.google.com/open?id=0BxuIkysU9OYuZGsySFdzRDEwNFEEitherway,what’simportanttorecognizenowisthatbyrecastingtheexpectedfutureflowofcorporatewealthintermsofROE,we’vecompletelychangedthegame.We’vetakenanimpracticalunwieldymessandturneditintosomethingverymanageable(areasonablenumberofclearlyidentifiableinputs)andcredible(amodeldominatedbythesinglemostpersistentmeasureofcompanyqualitywehave).Becausevaluationisfutureoriented,itcanneverbeanythingmorethananapproximation.Butasapproximationsgo,thisasgoodasit’slikelytoget.Undoubtedly,younoticedthattheformalstatementofRIMstillusesinfinity.WecouldhandlethatwithaterminalRIfigurethatisdividedbyk-g,thecostofequityminusapresumed(andsmaller)infinitegrowthrate.Butasnotedabove,we’lluseamoreconservativealternative:We’llterminateourseriesusingazero-growthfinal-yearvaluation.Nowthatwehavethetheorynaileddown,let’sstartimplementing.RIMInputsfromPortfolio123BeforeweactuallymodelonPortfolio123,I’mgoingtopresenttwoRIMspreadsheettemplates,asimplifiedversionandanexpandedversion.Assumingyou’rebuildingautomatedportfolios,asmostprobablydo,thesespreadsheetswillnotbepartofyourworkonPortfolio123soyoucanskipthissectionifyouwish.Irecommend,however,thatyoubuildatleastoneofthesesheetsandexperiment.Ican’timagineabetterwaytogetadeepfeelfortheprocessofvaluationthanbygoingthroughsuchanexercisewithindividualcompanies.Nomatterhowmuchtheoryormathanybodyknows,there’snotinglikegettingmetaphoricaldirtunderone’sfingernailsthroughstudyofcompaniesandcase-by-caseanalysisandvaluation.Thatwouldmakeahugedifferenceinhowyouapproachmodelbuilding.We’renotjustusingnumbers;everydata-pointinPortfolio123meanssomething.

Here’swhatweneedtoworkwiththeRIMspreadsheetsI’llpresent.Notethatnotallitemsareneededforeachspreadsheet,andwewon’tneedtheentirecollectionforthePortfolio123screen.

• CurrentStockPriceo Close(0)

• EPSEstimatesforcurrentandnextfiscalyears

o CurFYEPSMeano NextFYEPSMean

• EstimatedLong-TermEPSGrowthRate

o LTGrthMean(If,asmanydo,youthinkthesearesystemicallytoohigh,youcandeflatethemacrosstheboard;e.g.,LTGrthMean*.8(makingsureyoualsoaccountfortheadmittedlyremotepossibilityofanegativeprojection,perhapsthroughuseofascreeningfilter.Ifyoureallywanttobecreative,lookforwaystodeflatethemconditionallyusingtheEVALfunction).

• DividendPayoutRatioo PayRatioTTMo Youcanusuallyusethetrailing12monthratioaspublishedon

Portfolio123.Thesenumberstendtobetolerablypersistent.Butaberrationsoccur,as,forexample,whenacompanynewlyinitiatesadividendorwhenthetrailing12monthratiowasdistortedbytemporaryfactorsthatinflatedordepressedearnings.Youcanplaytheprobabilitiesandtrytodiversifythisaway,orusescreening/buyrulestorepelsignificantoddities.

o YoumightalsoexperimentwithPayRatio5YAvg

• BookValuepersharefromlatestandpriorfiscalyearso BVPSAo BVPSPY

• TerminalReturnonEquity

o Thisisthemostchallenginginput.It’stheROEweassumethecompanywillgenerateatsomepointinthefuturewhencompetitiveandotherbusinessesadvantagesthatpresentlyleadtoabove-orbelow-averagereturnshavehadtimetoreverttowardthemean.Wecanusetheindustryaveragetrailing12monthROEasanautomatedinputbutthisistheitemwe’dmostlikelywanttoreviseonourown.Theindustrytrailing12monthand5-yearaverageROEsandthecompanytrailing12monthandfive-yearaverageROEscancombinetoestablishacontextthatcanhelpusformulatearational

assumption,bearinginmindthatROEsaregenerallypersistentovertimesubjecttotendenciesofextremevaluestograduallyreverttowardthemean.

o ForthePortfolio123versionofRIM,wewon’tactuallyusethis.Butworkingwithspreadsheetsandcomingupwithassumptionswillbeanincrediblelearningexperience.IfIwereDonaldTrump,I’dtellyouthatit’sgoingtobe“amazing.”

• CostofEquityo Onpaper,thisinputseemshorrific,ifnotimpossible.Butweliveina

worldinwhichwe’dratherbevaguelyrightthanpreciselywrong.Wecanhandlethisinamannerthat,ifnotaccurate,shouldbesufficienttoavoidinterferingwiththeabilityofotherpartsofthemodeltogiveusinvestableanswers.WetouchedonthiswhenwediscussedNoise-Valueandthesamekindsofspit-and-chewinggumapproximationscanbeusedheretoo.

o Foryourreference,hereareGoogle-doclinkstoasetoffourPDFsIpreviouslypostedonthistopic

§ https://drive.google.com/open?id=0BxuIkysU9OYua3ZGOTNoMDZVTzA

§ https://drive.google.com/open?id=0BxuIkysU9OYuejRwVlUzZlpCRzQ

§ https://drive.google.com/open?id=0BxuIkysU9OYuNjNjRWdneHRKeU0

§ https://drive.google.com/open?id=0BxuIkysU9OYuS2QxX0ptRlZrdWc

TheResidualIncomeModelSpreadsheet–SimplifiedVersionFigure1illustratestheentirespreadsheet.Figure1

TomakesenseofFigure1,let’sworkwiththebasicRIMformulation:

• Valueequalscapitalplusthepresentvalueofexpectedenhancementstowealth.

o That’sinCellB16,whichisthesumofbookvalue(capital)plusCellE29plusCellF29,whicharethepresentvaluesofenhancementstowealthinyearsoneandtwo,plusCellG29,whichisathepresentvalueofperpetualwealthenhancementbeyondyeartwo.

• Enhancementtowealthequalsbookvalue(row19ofcolumnsE,FandG)multipliedbyabnormalreturnonequity(row21),whichisreturnonequity(row20)minusthecostofequity(cellB13).

• ThebookvaluecomputationsarebasedonBVt+1=BVt+NetIncomet–Dividendst

NoticethatROE,themostimportantcomponentoftheformula,isnotinput.It’sderivedfromtheotherdatainputs.ConsistentwiththeprinciplesofterminationvaluediscussedinconnectionwiththeDCFmodelabove,theterminalresidualincomecalculation(cellG29)isbasedonastaticperpetuity,ratherthaninfinitegrowth.Table1providesthealloftheformulaswe’llneed.

Table1Cell FormulaG9 =F9*(1+B10)B16 =D24+E29+F29+G29E19 =D11+(E9*(1-$D$12))F19 =E19+(F9*(1-$D$12))G19 =F19+(G9*(1-$D$12))E20 =E9/((D11+C11)/2)F20 =F9/((E19+D11)/2)G20 =G9/((F19+E19)/2)E21 =E20-$B$13F21 =F20-$B$13G21 =G20-$B$13D24 =D11E27 =(D11*E21)F27 =(E19*F21)G27 =(F19*G21)E28 =1+B13F28 =(1+B13)^2G28 =((1+B13)^2)*B13E29 =E27/E28F29 =F27/F28G29 =G27/G28

Aversionofthismodelthat’ssimplifiedevenfurther(onethatusesasingleROEcomputationforallthreeforecastyears)willbethebasisoftheRIMstrategywewillbuildbelowonPortfolio123.Butbeforeaddressingthat,let’slookatanexpandedversionoftheRIMmodel,onethatalsorequiresjusteightinputs,includingmostoftheonesseenhere,butoffersoneimportantavenueforapplicationofanalyticjudgment–theterminalROE.TheResidualIncomeModelSpreadsheet–ExpandedVersionFigure2illustratestheExpandedversionoftheResidualIncomeModelspreadsheet.

Figure2

Theconceptisthesameaswhatwesawabove;valuebeingthesumofbookvalueplusthepresentvalueoffutureresidualincome.Thedifferencesherearethelongerforecasthorizonandtheintroductionofauser-suppliedassumptionforterminalROE.The12-yearforecasthorizonusedhereconsistsofthreephases:

• TwoyearsofforecastsbasedonexplicitEPSestimates,withROEsandbookvaluesbeingderivedbasedonprior-yearbookvalueandthatportionofEPSnotpaidasdividends.

• FiveyearsofforecastsbasedonEPSassumptionsderivedfromthelong-termEPSgrowthrateassumption.ROEsduringthisphasecontinuetobederivedbasedonprioryearbookvalueandtheretainedportionofEPS.

• Afive-yearconvergenceperiodduringwhichthecompany’sROEgradually

approachesanassumedterminalperiod(ourmodelassumesastraight-linepattern).Duringthisinterval,ROEforeachyearisastartingpoint,ratherthananend-pointtothecomputations.

o Thefinalyearofthisperiodistheterminalvalue,basedonazero-growthforeverassumption.

TheterminalROEiswhatoneregardsasthecompany’sinherent,permanentlevelofROE;itsinherentlong-termcapacitytogeneratereturns.Foraninitial

assumption,weshouldconsiderusingthemedianROEsofprofitablecompaniesinthesameindustry.ThisreflectsageneralassumptionthatcompaniesinthesameindustryshouldeventuallyhavesimilarROEs,afterenoughtimehaspassedforfirm-specificaberrationstofade.Thatsaid,wealsohavetorecognizethatindustryclassificationsusedbyfinancialdatavendorsthatservePortfolio123andothersuchplatformsmaynotalwaysbeperfectlygranular.Forexample,twosoftwarecompaniesoneofwhichproducesgamingsoftwareforconsumersandanotherthatproducesenterprise-levelcyber-securitysoftwaremightbothbeclassifiedasSoftwarefirmsyetarguablyhavedifferentlong-termsustainableROEsevenifmanagerialtalentandachievementarethesame.Ontheotherhand,it’seasiertoarguethattwoindependentenergyexplorationfirmsshouldhavethesamelong-termROEs.Significantdifferencesobservedtoday,based,forexample,onthequalityofthepropertiesonwhichtheyaredrilling,couldbeexpectedtoeventuallydiminishassuminghitsandmissestendtoevenoutovertime.ThelevelofjudgmentrequiredregardingterminalROEisbynomeanssimple.That,however,isnotadeficiencyinthemodel.Allmodelsrequirejudgments.Thisparticularmodelfocusesmostofthejudgmentonfactorsthatbestlendthemselvestothatwhichiswellwithinthecapabilitiesofhumans:thoughtfulconsiderationofhistoryandthemakingofanalyticassumptionsregardingfuturecompetitiveness,efficienciesandsoforth.Tables2and3providetheformulasforthisspreadsheetmodel.

Table2

Cell FormulaF16 =E7*(1+$B10)CopyF16formulaintocolumnsG

throughJD17 =(D18/C8)-1E17 =(E18/D18)-1CopyE17formulaintocolumnsF

throughOD18 =C8+(D7*(1-C9))E18 =D18+(E7*(1-$C9))F18 =E18+(F16*(1-$C9))CopyF18formulaintocolumnsF

throughJK18 =J18*(1+K17)CopyK18formulaintocolumnsL

throughOD19 =D7/(AVERAGE(C8,D18))E19 =E7/(AVERAGE(D18:E18))F19 =F16/(AVERAGE(E18:F18))CopyF19formulaintocolumnsG

throughJK19 =J19+(($O19-$J19)/4)CopyK19formulaintocolumnsL

throughNO19 =B11D20 =D19-$B12CopyD20formulaintocolumnsE

throughO

Table3

Cell FormulaSTARTINGCAPITAL

C23 =C8FUTUREWEALTHCREATION–

FORECASTSD27 =(C8*D20)E27 =D18*D20CopyE27formulaintocolumnsF

throughND28 =1+$B$12E28 =(1+$B$12)^2F28 =(1+$B$12)^3G28 =(1+$B$12)^4H28 =(1+$B$12)^5I28 =(1+$B$12)^6J28 =(1+$B$12)^7K28 =(1+$B$12)^8L28 =(1+$B$12)^9M28 =(1+$B$12)^10N28 =(1+$B$12)^11D29 =D27/D28CopyD29formulaintocolumnsE

throughNFUTUREWEALTHCREATION–

TERMINALO31 =E18*D20O32 =((1+B12)^11)*$B$12O33 =O31/O32

RESULTSO10 =B13O11 =C23+SUM(D29:N29)+O33

APortfolio123RIMScreenWe’llstartwithascreenthatcalculatesvaluesbasedonasimpleversionoftheRIMmodelsimilartothatwhichwasdepictedinFigure8-9.NOTE:Thisscreenissavedwithgroupvisibilityhere:https://www.portfolio123.com/app/screen/summary/155018?st=0&mt=1#

• StartbyeliminatingcompaniesforwhichthedataislikelytobeunsuitableforcalculatingRIM-basedvaluations.

o Welimitconsiderationtocompanieswithpayoutratiosbetweenzeroand100percent.

o WeeliminatefirmsforwhichbookvaluesorEPSestimatesarenegative.

o Rules:§ PayRatioTTM>=0andPayRatioTTM<100§ BVPSA>0andCurFYEPSMean>0andNextFYEPSMean>0

• Establishacostofequity.Forthisparticularmodel,wetakeaverysimple

approach.Intheinterestofsimplicity,we’lluseanacrosstheboardassumptionforallequities.Ifyouwant,onyourown,youcantestsensitivitiestovaryingapproaches.

o Wedefinethecostofdebtastwicetheinterestrateonthe10-yearU.S.Treasuryissue.

o Wesetthecostofequityasfivepercentagepointsabovethecostofdebt

o Rules:§ ShowVar(@DbtCost,(close(0,#tnx))*2/10)§ ShowVar(@EqCost,(@DbtCost+5)/100)

• Defineyear-endbookvalues(B).

o Btisbookvaluepershareforthemostrecentlycompletedfiscalyear.o Bt1isBtplustheproductoftheyear-1EPSestimatemultipliedthe

retentionrate(1minusthepayoutratio)o Bt2isBtplusthesumoryear-1andyear-2EPSestimates,whichis

thenmultipliedtheretentionrate(1minusthepayoutratio)o Rules

§ ShowVar(@Bt,BVPSA)§ ShowVar(@Bt1,BVPSA+(CurFYEPSMean*(1-

(PayRatioTTM/100)))) § ShowVar(@Bt2,BVPSA+((CurFYEPSMean+NextFYEPSMean)*(

1-(PayRatioTTM/100))))

• DefineROEastheyear-1EPSestimatedividedbytheaverageofBtandBt1o Rule

§ ShowVar(@roe,CurFYEPSMean/Avg(@Bt,@Bt1))

• Calculatethecomponentsofthepresentvalueofeachresidualincomeitem.o v0isBto v1isabnormalROE(ROEminuscostofequity)multipliedbyBtwith

theresultdividedbythesumof1pluscostofequity

o v2isabnormalROE(ROEminuscostofequity)multipliedbyBt1withtheresultdividedbythesumof1pluscostofequityraisedtothesecondpower

o v3isabnormalROE(ROEminuscostofequity)multipliedbyBt1withtheresultdividedbythesumof1pluscostofequityraisedtothesecondpowerallofwhichisthenmultipliedbythecostofequity

o Rules§ ShowVar(@v0,@Bt)§ ShowVar(@v1,((@roe-@EqCost)*@Bt)/(1+@EqCost))§ ShowVar(@v2,((@roe-@EqCost)*@Bt1)/((1+@EqCost)^2))§ ShowVar(@v3,((@roe-

@EqCost)*@Bt2)/(((1+@EqCost)^2)*@EqCost))

• TheRIMvaluation,labeled@RIMval,isdefinedasthesumofv0+v1+v2+v3o Rule

§ ShowVar(@RIMval,@v0+@v1+@v2+@v3)

• Finally,wedefine@P2RIM,withisthecurrentpricedividedbythe@RIMval.o Rule

§ ShowVar(@P2RIM,close(0)/@RIMval)That’sit,theHolyGrailofourDCFmodel:@P2RIM,themarketpricedividedbyourcomputationoffairvalue.TestDrivingtheModelI’mgoingtousethePRussell3000universe,theiSharesRussell3000ETFbenchmark,anassumedslippageof0.25%,4-weekrebalancing,andaMAXtestingperiod(1/2/99–12/16/15).Forrollingbacktests,I’llassume4-weekholdingperiodsruneveryconsecutiveweek.Beforeweworkourwaydowntoinvestableresultsets,let’sgetsomesenseifthishasanypotentialatalltowork.I’mgoingtoaddrulesthatselectthemostfavorablyvalued20%andthen,alternatively,theleastfavorablyvalued20%.• bullishversion(lowvaluation)

o Frank("@P2RIM",#previous)<=20• Alternativebearishversion(highvaluation)

o Frank("@P2RIM",#previous)>=80Herearebacktestresultsforeach:

Table4 Presumed

Overvaluation BenchmarkPresumed

UndervaluationBasicBacktestAnnualizedReturn% 5.65% 5.15% 13.59%Stan.Dev.% 25.42% 15.82% 22.72%Max.Drawdown% -72.70% -55.77% -68.07%Sharpe 0.28 0.28 0.60Sortino 0.39 0.37 0.82Beta 1.38 -- 1.24AnnualizedAlpha% 1.00% -- 8.34%RollingBacktest(Excess4-weekReturns)Avg.ofAllPeriods +0.27% -- +0.81%Avg.ofUpPeriods +1.25% -- +3.34%Avg.ofDownPeriods -1.28% -- -0.14%Withallthehugeapproximationswemade,we’reclearlyontosomething.PopQuiz:DoyouthinkImissedsomethingimportantwhenbuildingthemodel?Theanswerwillbegivenlater.Let’sgoonandseeifwecanmakethisinvestable.Toaccomplishthat,weneedtogettheresultsetdowntoareasonablenumberofstocks:I’llsay15.I’mgoingtodothatwithaQuickRankbasedonestimaterevisioninthepastweek.Iknowthescreenispointingmetowardgoodvalues,sowhattheheck;I’llnarrowdownbygoingforthe15stockstheStreetmighthavemostlikelyturnedbullishoninthepastweek.Here’stheHigher-is-Bettersort:

• (CurFYEPSMean-CurFYEPS1WkAgo)/abs(CurFYEPS1WkAgo)Table5showsthetestresults.Table5 Model BenchmarkAnnualizedReturn% +15.85% 5.15%Stan.Dev.% 27.79% 15.82%Max.Drawdown% -67.55% -55.77%Sharpe 0.75% 0.28Sortino 0.88% 0.37Beta 1.32 --AnnualizedAlpha% 11.40% --Avg.ofAllPeriods +1.34% --Avg.ofUpPeriods +2.06% --Avg.ofDownPeriods +0.18% --Again,we’reontosomething.It’sinvestable.Isitperfect?Down-marketperformanceisn’tgreat.Andwedoseesomevolatility.Thesearenotthesortof

numbersadataminerwouldwanttoshow,butassomethingthat’sclearlytheorydriven(i.e.wehavereasontoexpectthetestresultstoberepresentativeofwhatwemightseegoingforwardwithlivemoney),it’snottheendoftheworld.Still,thegraphicofthetrend(Figure3)showssomelate-runvolatilitythatwarrantsattention.Figure3

Oneexplanationcomestomindsimplythroughawarenessofwhat’sbeengoingoninthemarket;valuehasnotbeenahotstylelately(asofthiswritingandtowardthelatterpartofthetestperiod).Let’stestthelatestyear,notagainsttheiSharesRussell3000benchmarkbutagainstadifferentone,theS&P1500PureValueIndex.Herearetheresults:

Figure5:One-YearTestagainstValueBenchmark

Table6:One-YearTestagainstValueBenchmark Model BenchmarkAnnualizedReturn% -0.17% -7.20%Stan.Dev.% 25.27% 16.64%Max.Drawdown% -23.32% -17.74%Sharpe 0.12 -0.32Sortino 0.19 -0.49Beta 1.40 --AnnualizedAlpha% 11.01 --Avg.ofAllPeriods -0.47% --Avg.ofUpPeriods +3.02% --Avg.ofDownPeriods -3.31% --Thisofferssomeinterestingmessages.Frist,wearenotnecessarilylookingatacaseinwhichaoncegoodmodelwentsour.Itisavaluemodelandcanbeexpectedtosufferduringperiodsinwhichvaluegoesoutoffavor.Butasavaluemodel,itstillgeneratesalpha.Weseethatitisvolatile.Whilethathurtsusinbadtimes(obviously),wehavenoshortageofupsidevolatilityduringgoodtimes.(ThelumpyrecenttrendswesawinFigure3don’tindicateafalteringstrategybut,rather,somebigralliesfollowedbycorrections.)Ifwewanttoassumethatoverthelongterm,goodperiodswilloutnumberbad,well,youknow.Still,itwouldbenicetogetabitofahandleonthedownside.Let’sgiveitashot.I’lladdthisscreeningrule:

• Rating("Basic:Quality")>75

Theideahereistrytocontrolsomeoftheriskcomponentinherentinvaluemodels.AnswertoEarlierPopQuiz:DidImisssomethingthefirsttimeout?Maybe.RecallthatIscreenedforvalueandthenwentrightintoasentiment-basedquickrank.Wasn’tIsupposedtohaveaddressedgrowthandrisk?Actually,Idid.Remember,thisvaluemodelisnotasimpleratio.It’sacomplex(byPortfolio123standards)formulainwhichgrowthandriskalreadyplayhugeparts(theLTGrowthestimateandROEbothfigureprominently,althoughthelatterisn’taddresseddirectlybutisaddressedthroughEPS/BVPS).Sowedon’tabsolutelyhavetoaddanything.Butthevolatilityweseeinthetestsmakesmewonderwhetherwecouldstandabitmoreintermsofriskmeasurement.HencemyadditionoftheQualityrankingsysteminthecontextofascreeningrule.Let’sretest(goingbacktotheiSharesRussell3000benchmarkandusingtheMaxperiod):Figure6

Table7 Model BenchmarkAnnualizedReturn% 16.34% 5.15%Stan.Dev.% 23.65% 15.82%Max.Drawdown% -67.62% -55.77%Sharpe 0.64 0.28Sortino 0.88 0.37Beta 1.13 --AnnualizedAlpha% 10.64% --Avg.ofAllPeriods +1.05% --Avg.ofUpPeriods +1.40% --Avg.ofDownPeriods +0.49% --

Wedefinitelymadeheadwayinourefforttotrimvolatility.Butsincewestillseethatweaknesstowardtheendofthetestperiod,let’sdoanotherclose-uponthelatestyear.Figure7:One-YearRetestagainstValueBenchmark

Table8:One-YearRetestagainstValueBenchmark Model BenchmarkAnnualizedReturn% -1.42% -7.20%Stan.Dev.% 16.56% 16.64%Max.Drawdown% -22.38% -17.74%Sharpe -0.62 -0.32Sortino -1.16 -0.49Beta 0.89 --AnnualizedAlpha% -5.42 --Avg.ofAllPeriods +0.88% --Avg.ofUpPeriods -0.22% --Avg.ofDownPeriods +1.77% --Wesetouttoreducevolatilityandwedidexactlythat.Thequestioniswhetherwewentoverboardintermsofthereturnwesacrificedintherecentperiod.Perhaps,hopefully,therewillbelesscostlywaystomanagethevolatility,otherwaystodefinetherisktest.Nowthatyouhavethemodel,understandwhatmakesvaluetick,andhavethisscreenavailabletoyou,I’mgoingtoleaveittoyoutocomeupwithideasforimprovingit.Remember,though,ifyouadaptthistothesimulationplatform,you’llhavetochangeShowVartoSetVar.

NextWe’redonewithValue.Idon’tmeantosuggestthere’snothingmoretolearnonthistopic.Therearealwaysnewthingstolearn.That’sthenatureoftheinvestingworld.Butatthispoint,youknowmorethanenoughtoworkeffectivelywithValueinyourstrategies.Actually,youprobablyknowaheckofalotmorethanmanyothersinthemarketsrightnow.Moreimportantly,younowhaveenoughofatheoreticalfoundationtocomeupwithnewideasofyourown.Soit’stimetomoveon.ThenextTopicwillbeonethat’salreadybeenintroducedandonethathopefully,younowhavemoreinterestinthanmightpreviouslyhavebeenthecase.It’sQuality.