1. Dullcorp Valuation Computations

2. load dullcorp_ga_data.xls local drive c:/program files/eval2 program files/thomson research saved data/ local drive c:/program files/eval2 program files/thomson research saved data/ set valuation date to 7/9/1998 set valuation date to 7/9/1998 set cost of debt = 10% set cost of debt = 10% set forecast horizon = 5 years set forecast horizon = 5 years set terminal sales growth = 0% set terminal sales growth = 0% Price = $3000.38. Price = $3000.38.

3. playing with eVal reset default forecasts for dullcorp: reset default forecasts for dullcorp: put neg 10% in exord item to make ROE=10%. Examine the RI model valuation. How does changing sales growth change value? put neg 10% in exord item to make ROE=10%. Examine the RI model valuation. How does changing sales growth change value? increase cash balance to 100% in yr 1. Examine RI and FCF model valuations. increase cash balance to 100% in yr 1. Examine RI and FCF model valuations. using the data center: using the data center: find a company with negative equity value (reset valuation date and use default forecasts) find a company with negative equity value (reset valuation date and use default forecasts) find a company with a huge ROE find a company with a huge ROE find an industry with high turnover/low margin find an industry with high turnover/low margin find an industry with low turnover/high margin find an industry with low turnover/high margin

4. time adjustments 1997 1998 1999 2000 2001 historical forecasted RI 1999 RI 2000 RI 2001 valuation date most current fiscal year end move RI flows ½ year earlier by multiplying valuation by (1+r e /2) move to valuation date by multiplying valuation by (1+r e (fraction of year))

5. year01234567 CE end10001200140016001800200021002205 NI forecast 100200300400500525551.25 Div implied-1000100200300425446.25 RI implied080160240320325341.25 Div*1.05315 330.75 RI*1.05336 352.80 when can you start using the perpetuity formula? r=10%, forecast g=5% after year 5 and beyond ?

6. Common Errors in Valuation e.g. common error is to assume D T+1 = (1+g)D T. D T+1 = NI T+1 – [CE T+1 – CE T ] = (1+g)NI T – [(1+g)CE T - CE T ] (1+g)D T = (1+g)NI T – [(1+g)CE T – (1+g)CE T- 1 ] 1.Starting the terminal value off with the wrong amount 2.Losing cash in the DCF model – its not operating but its not financing, its just GONE! 3.Inconsistent weighted average cost of capital in the DCF model / / http://papers.ssrn.com/sol3/papers.cfm?abstract_id=229445papers.ssrn.com/sol3/papers.cfm?abstract_id=229445 Lundholm/Okeefe CAR 2001

7. SalomonSmithBarney

8. Screening for misvalued stocks accrual measures accrual measures surprise measures surprise measures valuation measures valuation measures momentum measures (finance) momentum measures (finance) “smartmoney” measures (not here) “smartmoney” measures (not here)

9. Operating Accruals Definition: Operating Accruals = Earnings - Cash from Operations, deflated by average total assets Definition: Operating Accruals = Earnings - Cash from Operations, deflated by average total assets SCF Operating section: Earnings200 + depreciation+50 - Change in working capital -30 + non-cash special item charges+10 =Cash From Operations230 operating accruals Dechow and Ge (2005)

10. Operating Accruals and Future Stock Returns Dechow and Ge (2005)

11. Within the Operating Accrual portfolios, SI drive the results a SI if SI/TA >.02 Dechow and Ge (2005)

12. The Earnings Surprise Surprise = Surprise = (un-split-adjusted IBES actual EPS t – IBES forecast EPS t ) (un-split-adjusted IBES actual EPS t – IBES forecast EPS t )------------------------------------------------------------------ price per share t Sort into deciles in quarter t-1 and use the decile cutoffs to form earnings surprise portfolios for quarter t. Sort into deciles in quarter t-1 and use the decile cutoffs to form earnings surprise portfolios for quarter t. Take position 2 days after earnings announcement and hold for 1, 2 or 3 years. Take position 2 days after earnings announcement and hold for 1, 2 or 3 years. Focus (mostly) on extreme good and bad news portfolios Focus (mostly) on extreme good and bad news portfolios can use total assets per share at t-1 and get very similar results can use total assets per share at t-1 and get very similar results Doyle, Lundholm and Soliman 2005

13. The Big Result how big is a big surprise? Suppose P=$20, E=$1, or.25/qtr. ½ percent of 20 is 10 cents, so report 35 cents EPS when market was expecting 25 cents.

14. Future returns controlling for risk (matched on size and book-to-market)

15. Future returns after controlling for risk and other market anomalies All independent variables are sorted into ten portfolios based on prior quarter’s decile rank. Regressions estimated quarterly (mean coefficients reported). Fama McBeth t-statistics with the Newey-West correction for serial correlation.

16. one year returns beginning each quarter (after risk controls) with non-overlapping intervals

17. Extreme firms continue to Surprise

18. earnings surprise/price >.005 (CFO-NI)/price >.05 if 6 month stock return > 30% then beat market by 24%!

19. Price equals the current book value plus the discounted sum of expected future residual income (abnormal earnings). modeling residual income persistence Define CE o as book value of Common Equity at time 0 RI t as residual income at time t, = (NI t – r e CE t-1 )

20. persistence in RI need forecasts of future RI need forecasts of future RI Suppose RI t =  RI t-1 +  t,  between 0 and 1, so that Suppose RI t =  RI t-1 +  t,  between 0 and 1, so that RI 1 =  RI 0, RI 2 =  2 RI 0, etc. Then Then Dechow and Sloan (1999 ?)

21. Some models of persistence If  =1 then If  =1 then If  =0 then If  =0 then or estimate  =.62 or estimate  =.62

22.  =.62 model

23. a better model of  RI t+1 =.62RI t RI t+1 =.62RI t RI t+1 =-.02+.61RI t RI t+1 =-.02+.61RI t -.37RI t * |RI t /CE t | - 1.21RI t * |special t /TA t | so, if |RI t /CE t | =.10 and |special t /TA t | =.01 then RI t+1 =-.02+.61-.37(.10) - 1.21(.01) =.541RI t

24. the results buy dogs, sell glamour

25. miscellaneous observations notice that every time we add context to the analysis the performance improves notice that every time we add context to the analysis the performance improves returns to talent and hard work! returns to talent and hard work! what about risk? what about risk? other variables not discussed other variables not discussed P/B – is it risk? P/B – is it risk? 6 month stock return momentum 6 month stock return momentum