A New Model for Stock Valuation Zhiwu Chen Professor of Finance, Yale University Co-Chairman, ValuEngine Inc.

The ValuEngine™ Stock-Valuation Model èBased on recent research by Bakshi & Chen (1997), Chang, Chen & Dong (1998) … èApplying the methodology from bond valuation & options pricing (e.g., the Vasicek, the Cox-Ingersoll- Ross models, the Black-Scholes, …)

The ValuEngine™ Model èFundamental Variables: current EPS, expected future EPS, and 30-yr bond yield è Firm-specific parameters: è EPS growth volatility è Long-run EPS growth rate è Duration of business-growth cycle è Systematic or beta risk of the firm è Correlation between the firm's EPS and the interest-rate environment è 30-yr Treasury yield’s parameters: è Its long-run level è Interest-rate volatility è Duration of interest-rate cycle

The Formula

Research Findings

Mispricing Distribution Across Stocks Under- to overvaluation

Model Valuation and Average Return

Understanding Valuation Measures

Behavior of Book/Market Ratio over Time This figure shows the average B/M ratio path for each quartile obtained by sorting all stocks according to their B/M ratios as of January 1990.

Behavior of E/P Ratio This figure shows the average E/P ratio path for each quartile obtained by sorting all stocks according to their E/P ratios as of January You would like to see the qartiles crossing each other over time. Yes, they do to some extent.

Behavior of ValuEngine Model Mispricing This figure shows the average ValuEngine Model mispricing path, for each quartile obtained by sorting all stocks according to their mispricing levels as of January The quartiles switch from over- to undervalued, and vice versa, every few years! Q1 Q4 Q1 Q4 Q1 Q4 Q1 Q4

Applying ValuEngine™ : Back-Test Results

ValuEngine™ Strategy One: focus on absolute valuation Buy stocks that are undervalued by more than 10% and with a momentum rank higher than 70. Sell a stock if it becomes at least 10% overvalued or has a momentum rank below 60.

ValuEngine™ vs S&P 500

Investment Styles and Performance

Investment Styles and Growth

ValuEngine™ Strategy Two: focus on relative-valuation Buy Criteria: stock must have a mispricing rank and a momentum rank greater than 70 (on a scale). Sell Criteria: mispricing or momentum rank falls below 60.

Style One : combining ValuEngine™ mispricing with size

Style 2 : combining ValuEngine™ mispricing with Book/Market

Style 3 : combining ValuEngine™ mispricing with momentum

Alpha & Beta : for Mispricing & Momentum portfolios All the portfolios here are same as in preceding chart, based on Mispricing & Momentum.

Residual-Income Model Mispricing & Momentum Mispricing in this chart is determined by the residual-earnings model as implemented in Lee, Myers and Swaminathan (1998), where book value, EPS estimates, and CAPM-like expected returns are used as the basic inputs. Then, the mispricing quintiles are constructed and sorted accordingly.

Using ValuEngine™ to Forecast the Stock Market The “% of Undervalued Stocks” path indicates the then-current percentage of stocks that were undervalued at the time, relative to the entire stock universe. The other path is the then-1-yr- forward return on the S&P 500 index.

Conclusions –The best investment strategy: Combine ValuEngine valuation with momentum! –Hot and Cold stock groups switch every few years

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