- 1 - lifecycle returns, inc. © 2004 all rights reserved comparative accuracy of free cash flow...

- 1 -LIfeCycle Returns, Inc.

© 2004 All Rights Reserved

COMPARATIVE ACCURACY OF COMPARATIVE ACCURACY OF FREE CASH FLOW MODEL FREE CASH FLOW MODEL

METHODOLOGIES AND PARAMETERSMETHODOLOGIES AND PARAMETERS

By

Rawley Thomas

President

LifeCycle Returns, Inc.

February 29, 2004

[email protected]

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LIfeCycle Returns, Inc.© 2004 All Rights Reserved

Comparative Accuracy of Free Cash Flow Models 2-29-04

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KEY VALUE MANAGEMENT KEY VALUE MANAGEMENT OBJECTIVE FUNCTIONOBJECTIVE FUNCTIONAND HOW TO MEASURE IT FOR SINGLE AND HOW TO MEASURE IT FOR SINGLE

COMPANIES AND ACROSS LARGE UNIVERSESCOMPANIES AND ACROSS LARGE UNIVERSES(“What Gets Measured Gets Done”)(“What Gets Measured Gets Done”)

Corporate Managers

– Explain Current Stock Price Level

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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 and parameters

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

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ACROSS A UNIVERSE OF 20,000ACROSS A UNIVERSE OF 20,000++ COMPANY- COMPANY-YEARS, TRACKING ERROR IMPROVEMENT YEARS, TRACKING ERROR IMPROVEMENT CHARTS MEASURE THE COMPARATIVE CHARTS MEASURE THE COMPARATIVE ACCURACY OF:ACCURACY OF: Models

Methodologies

Parameters

Tracking error equals the % absolute difference between the Model Intrinsic Value and the actual stock price at Fiscal Year + 3 Months

LOG2 of % Absolute Model Error versus

Actual Price - Fiscal Year +3 Months 1994-2002

63 79

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

Cumulative % of Universe

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ADVANTAGES OF THE LCRT ADVANTAGES OF THE LCRT TRACKING ERROR IMPROVEMENT TRACKING ERROR IMPROVEMENT

CHARTSCHARTS Don’t depend on the distribution and don’t

assume Gaussian Normality

Cover the entire universe and all company years without “fudging” outliers with elimination or winsorization

Summarize very large amounts of time series and cross sectional data on one simple chart

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FOR THE FREE CASH FLOW PERPETUITY MODEL, FOR THE FREE CASH FLOW PERPETUITY MODEL, THE GROWTH RATE METHODOLOGY MAKES A THE GROWTH RATE METHODOLOGY MAKES A

SMALL 8%* DIFFERENCE IN ACCURACYSMALL 8%* DIFFERENCE IN ACCURACY



66 71



* 8% = 100%(71/66 -1)

•Median 3-year median growth rate in assets for the industry is the most accurate growth rate methodology with a tracking error of 65.7%.

•3-year compounded growth rate in assets for the company is the least accurate growth rate methodology with a tracking error or 70.7%.

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MEDIAN TRACKING ERRORS FOR GROWTH RATE MEDIAN TRACKING ERRORS FOR GROWTH RATE METHODOLOGIES FOLLOW A NARROW 8% RANGE METHODOLOGIES FOLLOW A NARROW 8% RANGE

FROM 65.7 TO 70.7FROM 65.7 TO 70.7

65.766.266.666.866.866.967.067.367.368.368.468.969.169.370.070.7

0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 80.0

Median 3-Year Median Growth in Assets for IndustryMedian 1-Year Growth in Assets for IndustryMedian 3-Year Compound Growth in Assets for Industry

Median 3-Year Median Growth in Net Sales for IndustrySustainable Growth Rate on EquityMedian 1-Year Growth in Net Sales for IndustryMedian 3-Year Sustainable Growth Rate on Equity for IndustryMedian 1-Year Sustainable Growth Rate for Industry

Median 3-Year Compounded Growth in Net Sales for IndustryMedian 3-Year Sustainable Growth Rate on Equity1-Year Growth in Assets3-Year Median Growth in Assets1-Year Growth in Net Sales

3-Year Median Growth in Net Sales3-Year Median Growth in Net Sales3-Year Compounded Growth in Assets

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A 5% EQUITY RISK PREMIUM PARAMETER A 5% EQUITY RISK PREMIUM PARAMETER MINIMIZES TRACKING ERRORS FOR 45% MINIMIZES TRACKING ERRORS FOR 45%

OF THE UNIVERSEOF THE UNIVERSE



65 95



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INDUSTRY MEDIAN BETA’S DOMINATE COMPANY INDUSTRY MEDIAN BETA’S DOMINATE COMPANY LCRT BETA’S, BUT ONLY A 5%* DIFFERENCE EXISTS LCRT BETA’S, BUT ONLY A 5%* DIFFERENCE EXISTS

WITH ALL BETA’S = 1.00WITH ALL BETA’S = 1.00



67 97



* 5% = 100%(68.9/65.7 -1)

The low sensitivity of the tracking error results to employing the median industry beta over beta = 1.00 adds additional empirical evidence against the usefulness of CAPM beta as a measure of risk.

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THE LOWEST ERRORS OCCUR WITH 1-YEAR THE LOWEST ERRORS OCCUR WITH 1-YEAR TIME PERIODS FOR EXCESS GROWTHTIME PERIODS FOR EXCESS GROWTH

66 85 120





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