Dullcorp Valuation Dullcorp Valuation ComputationsComputations

load dullcorp_ga_data.xlsload dullcorp_ga_data.xls

local drive c:/program files/eval2 local drive c:/program files/eval2 program files/thomson research saved program files/thomson research saved data/data/

set valuation date to 7/9/1998set valuation date to 7/9/1998 set cost of debt = 10%set cost of debt = 10% set forecast horizon = 5 yearsset forecast horizon = 5 years set terminal sales growth = 0%set terminal sales growth = 0% Price = $3000.38.Price = $3000.38.

playing with eValplaying with eVal

reset default forecasts for dullcorp:reset default forecasts for dullcorp: put neg 10% in exord item to make ROE=10%. Examine put neg 10% in exord item to make ROE=10%. Examine

the RI model valuation. How does changing sales the RI model valuation. How does changing sales growth change value? growth change value?

increase cash balance to 100% in yr 1. Examine RI and increase cash balance to 100% in yr 1. Examine RI and FCF model valuations.FCF model valuations.

using the data center:using the data center: find a company with negative equity value (reset find a company with negative equity value (reset

valuation date and use default forecasts)valuation date and use default forecasts) find a company with a huge ROEfind a company with a huge ROE find an industry with high turnover/low marginfind an industry with high turnover/low margin find an industry with low turnover/high marginfind an industry with low turnover/high margin

time adjustmentstime adjustments

1997 1998 1999 2000 2001historical forecasted

RI1999 RI2000 RI2001

valuation date

most current fiscal year end

• move RI flows ½ year earlier by multiplying valuation by (1+re/2)

• move to valuation date by multiplying valuation by (1+re(fraction of year))

year 0 1 2 3 4 5 6 7

CE end 1000 1200 1400 1600 1800 2000 2100 2205

NI forecast   100 200 300 400 500 525 551.25

Div implied -100 0 100 200 300 425 446.25

RI implied 0 80 160 240 320 325 341.25

Div*1.05 315330.75

RI*1.05 336352.80

when can you start using the perpetuity when can you start using the perpetuity formula?formula?

r=10%, forecast g=5% after year 5 and beyond

?

Common Errors in ValuationCommon Errors in Valuation

e.g. common error is to assume DT+1 = (1+g)DT .

DT+1 = NIT+1 – [CET+1 – CET] = (1+g)NIT – [(1+g)CET - CET]

(1+g)DT = (1+g)NIT – [(1+g)CET – (1+g)CET-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=229445

Lundholm/Okeefe CAR 2001

SalomonSmithBarneySalomonSmithBarney

Screening for misvalued Screening for misvalued stocksstocks

accrual measuresaccrual measures surprise measuressurprise measures valuation measuresvaluation measures momentum measures (finance)momentum measures (finance) ““smartmoney” measures (not here)smartmoney” measures (not here)

Operating AccrualsOperating Accruals Definition: Definition: Operating Accruals = Operating Accruals = Earnings - Cash from Earnings - Cash from

Operations, deflated by average total assetsOperations, deflated by average total assets

SCF Operating sectionSCF Operating section::EarningsEarnings 200200+ depreciation+ depreciation +50+50- Change in working capital- Change in working capital -30 -30+ non-cash special item charges+ non-cash special item charges

+10+10=Cash From Operations=Cash From Operations 230230op

erat

ing

accr

uals

Dechow and Ge (2005)

Operating Accruals and Operating Accruals and Future Stock ReturnsFuture Stock Returns

Dech

ow

and G

e (

2005)

Within the Operating Accrual Within the Operating Accrual portfolios, SI drive the resultsportfolios, SI drive the results

a SI if SI/TA > .02

Dechow and Ge (2005)

The Earnings SurpriseThe Earnings Surprise

Surprise =Surprise = (un-split-adjusted IBES actual EPS(un-split-adjusted IBES actual EPStt – IBES forecast EPS – IBES forecast EPStt))

------------------------------------------------------------------------------------------------------------------------------------

price per shareprice per sharett

Sort into deciles in quarter t-1 and use the decile cutoffs to form Sort into deciles in quarter t-1 and use the decile cutoffs to form earnings surprise portfolios for quarter t.earnings surprise portfolios for quarter t.

Take position 2 days after earnings announcement and hold for Take position 2 days after earnings announcement and hold for 1, 2 or 3 years.1, 2 or 3 years.

Focus (mostly) on extreme good and bad news portfoliosFocus (mostly) on extreme good and bad news portfolios can use total assets per share at t-1 and get very similar resultscan use total assets per share at t-1 and get very similar results

Doyle, Lundholm and Soliman 2005

The Big ResultThe Big Result

Surprise Portfolio

N

Average Minimum in

Surprise Portfolio

Mean Surprise

Mean Ret1yr

Mean Ret2yr

Mean Ret3yr

1 16,254 -0.0397 -0.0458 -0.0496 -0.0943 2 15,830 -0.0120 -0.0062 -0.0195 -0.0537 -0.0581 3 15,618 -0.0042 -0.0023 -0.0441 -0.0781 -0.1181 4 8,050 -0.0016 -0.0013 0.0151 -0.0188 -0.0184 5 26,344 -0.0005 -0.0001 -0.0394 -0.0668 -0.1198 6 13,007 -0.0000 0.0002 0.0065 -0.0009 -0.0199 7 16,913 0.0004 0.0007 0.0197 0.0164 -0.0019 8 15,940 0.0011 0.0016 0.0344 0.0385 -0.0093 9 15,843 0.0023 0.0033 0.0588 0.0903 0.0641 10 15,990 0.0052 0.0126 0.0937 0.1493 0.1426

Hedge Return (Portfolio 10 – Portfolio 1) 0.1395 0.1989 0.2369

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.

Future returns controlling for risk Future returns controlling for risk (matched on size and book-to-(matched on size and book-to-

market)market)

Surprise Portfolio

N

Average Minimum in

Surprise Portfolio

Mean Surprise

Mean Ret1yr

Mean Ret2yr

Mean Ret3yr

1 14638 -0.0397 -0.0459 -0.0515 -0.0741 2 14562 -0.0120 -0.0062 -0.0260 -0.0220 0.0125 3 14242 -0.0042 -0.0023 -0.0288 -0.0200 -0.0076 4 7475 -0.0016 -0.0013 -0.0095 -0.0106 -0.0261 5 24960 -0.0005 -0.0001 0.0040 0.0258 0.0662 6 12273 0.0000 0.0002 -0.0015 0.0288 0.0218 7 15868 0.0004 0.0007 0.0231 0.0676 0.0925 8 14864 0.0011 0.0016 0.0465 0.0993 0.0933 9 14661 0.0023 0.0033 0.0532 0.1159 0.1216 10 14526 0.0052 0.0126 0.0868 0.1792 0.2095

Hedge Return (Portfolio 10 – Portfolio 1) 0.1327 0.2307 0.2836

Future returns after controlling Future returns after controlling for risk and other market for risk and other market

anomaliesanomalies

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.

Dependent Variable

Intercept Surprise Beta Book

to Market

Size Accruals Momentum Pro Forma Exclusions

SUE

Ret1yr -0.020 (-0.44)

0.097 (7.36)

0.092 (1.34)

0.029 (0.54)

-0.067 (-1.15)

-0.089 (-8.18)

0.047 (1.63)

-0.041 (-4.01)

0.044 (0.72)

Ret2yr

-0.016 (-0.14)

0.163 (8.74)

0.221 (1.89)

0.013 (0.11)

-0.125 (-1.59)

-0.145 (-7.49)

-0.004 (-0.11)

-0.066 (-3.19)

0.034 (0.48)

Ret3yr

-0.050 (-0.37)

0.197 (8.00)

0.291 (3.11)

0.046 (0.30)

-0.120 (-0.30)

-0.197 (-9.27)

-0.023 (-0.75)

-0.101 (-7.32)

0.027 (0.31)

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

intervalsintervals

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

0.3

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Year

Ab

no

rmal

Ret

urn

Qtr. 1 Qtr. 2 Qtr. 3 Qtr. 4

Extreme firms continue to Extreme firms continue to SurpriseSurprise

-0.006000

-0.004000

-0.002000

0.000000

0.002000

0.004000

0.006000

0 1 2 3 4 5 6 7 8 9 10 11 12

Current and Future Quarters

Med

ian

Ea

rnin

gs S

urp

rise

Lowest SurpriseSurprise Portfolio 2Surprise Portfolio 3Surprise Portfolio 4Surprise Portfolio 5Surprise Portfolio 6Surprise Portfolio 7Surprise Portfolio 8Surprise Portfolio 9Highest Surprise

1 2 3 4 5 6 7 8 9 101

3

5

7

9

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 yr stock return

rank_acc

rank_surp

0.1-0.15

0.05-0.1

0-0.05

-0.05-0

-0.1--0.05

-0.15--0.1

earnings surprise/price >.005

(CFO-NI)/price > .05

if 6 month stock return > 30% then beat market by 24%!

Price equals the current book value plus the discounted sum of expected future residual income (abnormal earnings).

1

0 )1(t

tt

ee RIrCEP

modeling residual income modeling residual income persistencepersistence

Define CEo as book value of Common Equity at time 0

RIt as residual income at time t, = (NIt – reCEt-1)

persistence in RIpersistence in RI

need forecasts of future RIneed forecasts of future RI

Suppose RISuppose RItt = = RIRIt-1t-1 + + t t , , between between 0 and 1, so that0 and 1, so that

RIRI1 1 = = RIRI0, 0, RIRI2 2 = = 2 2 RIRI0 0 , etc., etc. Then Then

000 1RI

rCEP

Dechow and Sloan (1999 ?)

Some models of persistenceSome models of persistence

If If =1 then=1 then

If If =0 then=0 then

or estimate or estimate =.62=.62

001

Err

P

000 3.1 RICEP

00 CEP

12. ,1 000

rRI

rCEP

000 12.1RICEP

=

.62 model

a better model of a better model of

RIRIt+1t+1=.62RI=.62RItt

RIRIt+1t+1=-.02+.61RI=-.02+.61RItt

- .37RI- .37RIt t * * |RI|RItt/CE/CEtt|| - 1.21RI - 1.21RIt t * * |special|specialtt/TA/TAtt||

so, if so, if |RI|RItt/CE/CEtt|| = .10 and = .10 and |special|specialtt/TA/TAtt|| = .01 = .01

then RIthen RIt+1t+1=-.02+.61-.37(.10) - 1.21(.01) = .541RI=-.02+.61-.37(.10) - 1.21(.01) = .541RItt

the resultsthe results

Next Year’s Return

Conditional RI

Unconditional RI

Pure Earnings

Pure Book Value

1st decile .086 .111 .118 .118

10th decile .212 .210 .207 .191

Hedge return

.126 .099 .089 .073

buy dogs, sell glamour

miscellaneous observationsmiscellaneous observations

notice that every time we add context notice that every time we add context to the analysis the performance to the analysis the performance improvesimproves returns to talent and hard work!returns to talent and hard work!

what about risk?what about risk?

other variables not discussedother variables not discussed P/B – is it risk?P/B – is it risk? 6 month stock return momentum6 month stock return momentum