1. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 1 - VALUATION MODELS: ACCURACY AND PREDICTIVE CAPABILITY (A WORK-IN-PROGRESS) Financial Management Association International New Orleans, Louisiana October 9, 2004 By Rawley Thomas President LifeCycle Returns, Inc. Rawley@LCRT.com

2. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 2 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE CONCEPT OF VALUE MANAGEMENT THE CONCEPT OF VALUE MANAGEMENT A strong correlation exists between enterprise value and the spread between CER (cash economic return) and cost of capital Econometric DCF models can be built and validated against historical data to quantify this correlation and identify the key operating drivers which most significantly impact value Managements can use these models to analyze their own corporate performance and to improve their decision making and value generation Portfolio managers can use these models for buy / sell decisions

3. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 3 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform IN A CAREFULLY CONTROLLED EXPERIMENT IN AN ECONOMICS LABORATORY, VERNON SMITH et. al. DEMONSTRATES SIGNIFICANT DIFFERENCES OF TRADED PRICES FROM KNOWN INTRINSIC VALUES Vernon L. Smith, Gerry L. Suchanek, and Arlington W. Williams, “Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets,” in Vernon Smith, Papers in Experimental Economics, Cambridge University Press, Cambridge, 1991, pp. 339- 371, chart from p. 352.

4. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 4 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform NOTICE THE SAME PATTERN IN AN INTRINSIC VALUE CHART WHICH ENABLES US TO VISUALIZE THE MEASUREMENT OF ACCURACY OF A DCF MODEL PRICE LEVEL FOR HP USING ONLY ACTUAL REPORTED FINANCIAL DATA AND THE SAME GLOBAL PARAMETERS ACROSS THE ENTIRE UNIVERSE TO DRIVE A MECHANICAL LIFE CYCLE FORECAST OF CASH FLOWS FOR EACH COMPANY Notice the large high low variation around the intrinsic valuations, providing opportunity for profitable trading The Absolute “Tracking” Error Intrinsic Value vs. Actual Equals the Absolute Geometric Mean Error Between The Intrinsic Value Red Line And Closing Prices at Fiscal Year + 3 Months (hollow circles) Over the Number of Years LCRT Residual Income LCRT 15.2 Residual Income 65.2

5. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 5 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform FOR HEWLETT-PACKARD, A FREE CASH FLOW MODEL DISPLAYS LOWER ACCURACY THAN LCRT (OF COURSE, H-P IS ONLY A SAMPLE OF ONE) LCRT Free Cash Flow LCRT 15.2 Free Cash Flow 23.5 Absolute “Tracking” Error

6. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 6 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform BEHAVIORAL EXPLANATIONS OF VIOLATIONS OF INSTANTANEOUSLY EFFICIENT MARKET’S HYPOTHESIS People employ significantly different and inconsistent models of fundamental valuation, relying on various forecasts Depending on the weights of all the classes of people buying and selling a stock at any point in time, the actual price will diverge significantly from the long term intrinsic value Strongly held academic beliefs in instantaneous market efficiency impede empirical research to show otherwise Price event studies only demonstrate that the market reacts in the correct direction, but not necessarily by the correct amount Robust, accurate DCF models of intrinsic valuation are required to empirically test instantaneous market efficiency

7. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 7 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform SEVERAL PROFESSORS ARE COLLABORATING WITH LCRT TO DETERMINE THE ROBUSTNESS AND ACCURACY OF TRADITIONAL MODELS AS NULL HYPOTHESES Sally Webber of NIU and Doug Clinton of NIU – EVA ® or Residual Income Models – Feltham-Ohlson Model Adam Gehr of DePaul – Dividend Discount Models

8. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 8 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform TESTED MODELS 8 X EBITDA Feltham-Ohlson Residual Income Free Cash Flow LCRT

9. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 9 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform COMPARISON OF FELTHAM-OHLSON AND FREE CASH FLOW PERPETUITY Feltham-Ohlson Based on market value of equity/ operating assets regressed against return on assets, change in return on assets, and growth rate in assets From Jing Liu and James A. Ohlson, “The Feltham-Ohlson Model: Empirical Implications,” Journal of Accounting, Auditing and Finance, 2000, v15 [3, Summer], pp. 321-331, especially p. 326-327. Programmed with the aid of Sally Webber, Accounting Professor, Northern Illinois University Free Cash Flow Perpetuity Based on growing free cash flow for T years and capitalizing the terminal year’s free cash flow into perpetuity Free cash flow = income after taxes + depreciation and amortization – non-operating items after tax – normalized capital expenditures – working capital additions The terminal year’s cash flow is capitalized by a CAPM nominal discount rate less a nominal growth rate From specifications by Dan Van Vleet of Willamette

10. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 10 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform COMPARISON OF RESIDUAL INCOME AND LCRT Residual Income From PV of growing excess residual income (EVA ® ) for T years plus release of capital at terminal value employing a CAPM cost of capital Bennett Stewart, The Quest for Value, Harper Business, 1991, especially p. 324-325. Programmed with the aid of Sally Webber, Accounting Professor, Northern Illinois University LifeCycle Returns (LCRT) From PV of net cash flows for 50+ years using a market derived discount rate Net cash flows derive from fading growth rates and cash economic returns applied to constant dollar gross investment less replacement assets less growth in gross investment See Bartley J. Madden, CFROI Valuation: A Total System Approach to Valuing the Firm, Butterworth-Heinemann, Oxford, 1999 and LCRT.com

11. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 11 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform Income + Depreciation and Amortization +/- Inflation Adjustments +/- Finance / Non-Operating Expense Adjustments Assets +Accumulated Depreciation +Inflation Adjustments +/- Finance / Non-Operating Balance Sheet Adjustments Cash Economic Return (CER)* Constant Dollar Gross Asset Base Super Sector CER Fade-To Company Cash Economic Return (Fade From) Company Cash Economic Return Fade-To CER Fade Rate Super Sector Growth Fade-To Company Past CapEx Real Growth Rate and Real Sustainable Growth Rate (Fade From) Super Sector Gross Asset Growth Fade Rate Company Specific Real Investors’ Discount Rate, Adjusted for Leverage, Asset Mix, and Life = Enterprise Intrinsic Value + Cash – Debt = Equity Intrinsic Value ⁄ Number of Shares = Intrinsic Value Per Share LCRT FRAMEWORK Accounting Constant Dollar Cash Economic Cash Real Rates of Return on Un-Depreciated Gross Assets (Reflecting Real IRR of all Projects Currently in Place) Valuation Asset Mix Asset Life Life Cycle Valuation Model Super Sectors Industrials Utilities Financials (*Real ROE)

12. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 12 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform Income$206 A: Eliminate Non-OperatingSpecial Extraordinary Items After Tax33 Items(-) Non-operating Expense After-Tax(16) B: Translate to CashNon-Cash Charges333 C: Restate for InflationInflation Gain on Non-Fixed Assets14 D: Eliminate LeverageAfter-Tax Interest (Debt and Operating Leases)134$781 $206Rentals – Principal Payments77Current Dollar IncomeE: Capitalize Expenses(-) Advertising and R & D After Tax(0)Gross Cash Flow AssetsTotal Assets$5,825Current Dollar $5,825A: Eliminate Non-Operating(-) Non-Operating Assets(137)Investor Gross Items(-) Purchase Goodwill(1,531)Cash Receivables Reserve23Investment B: Translate to Cash Invest.LIFO Reserve141$5,704 Accumulated Depreciation1,580 C: Restate for Inflation Inflation Adjustments to Land, Gross Plant and Deferred Taxes249 D: Eliminate LeverageGross Leased Property from Operating Leases1,202 E: Capitalize ExpensesCapitalized Advertising, R & D0 F: Capital Owner Cash Invest. (-) Operating Non-Interest Bearing Liabilities(1,648) CASH ECONOMIC RETURN EXAMPLE: ACCOUNTING TO CASH SUPERVALU– 2001 ($Millions)

13. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 13 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform CASH ECONOMIC RETURN EXAMPLE: CASH TO ECONOMICS SUPERVALU– 2001 ($ MILLIONS) Current Dollar Gross Cash Flow $781 Non-Depreciating Asset Release $727 ($5,704) Current Dollar Investor Gross Cash Investment Economic Life: 11.55 Years Cash Economic Return - IRR: 9.09% YearsIRR 118.62 129.48 11.559.09

14. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 14 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform LIFE CYCLE OF CASH ECONOMIC RETURNS (CER) Firm Fading CER* CER Momentum Effect Firm CER Fade-To Super Sector CER Fade-To Firm CER Fade-To Difference Firm Discount Rate, Adjusted for Leverage, Asset Mix, and Asset Life Cash Flows continue for 50 Years => Super Sectors Industrials Utilities Financials (*Real ROE)

15. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 15 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform TRADITIONAL ACCOUNTING MEASURES FIRST UNDERSTATE AND THEN OVERSTATE ECONOMIC RETURNS AS ASSETS AGE (ASSUMING CONSTANT OUTPUT = CONSTANT DOLLAR LEVEL ANNUITY) (A DESIRED ANNUAL PERFORMANCE MEASURE REFLECTS THE PROJECT IRR) NOTE: The Annual CER each and every year precisely equals the IRR of the project. -$10,000 PROJECT $1,740 Life = 8 Years IRR = 8.00% Annual Performance Measures of Project Year 12345678 Income490 Depreciation1,250 Gross Cash Flow1740 Gross Plant10000 Accumulated Depreciation125025003750500062507500875010000 Net Plant87507500625050003750250012500 Return on Net Assets = RONA = Income/Net Plant5.60%6.53%7.84%9.80%13.07%19.60%39.20%∞ Cash Economic Return (CER)8.00% Difference-2.40%-1.47%-0.16%1.80%5.07%11.60%31.20%∞ Return on Gross Assets 17.40%

16. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 16 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform LCRT’S RESEARCH METHODOLOGY CONTRASTS SHARPLY WITH THE TRADITIONAL VALUATION APPROACH 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 “spot intrinsic valuation” models and parameters Extends the best models to use as terminal values in traditional “plan intrinsic valuations” May eventually test the best models with forecast security analyst data

17. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 17 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform ACROSS A UNIVERSE OF 20,000 + COMPANY- YEARS, TRACKING ERROR IMPROVEMENT CHARTS MEASURE THE COMPARATIVE 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 LOG 2 of % Absolute Model Error versus Actual Price - Fiscal Year +3 Months 1994-2002 63 79 Cumulative % of Universe

18. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 18 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform ADVANTAGES OF THE LCRT TRACKING ERROR IMPROVEMENT CHARTS 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

19. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 19 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform LCRT BETA’S FOR THE RESIDUAL INCOME MODEL HAVE SLIGHTLY BETTER TRACKING ERRORS THAN MEDIAN INDUSTRY BETA’S, BUT LESS THAN A 1%* DIFFERENCE EXISTS BETWEEN MEDIAN INDUSTRY BETA’S AND BETA’S = 1.00 LOG 2 of % Absolute Model Error versus Actual Price - Fiscal Year +3 Months 1994-2002 59 63 Cumulative % of Universe 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. * 0.5% = 100%(63.4/63.1 -1)

20. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 20 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform EMPIRICAL EVIDENCE: LCRT’s MODEL IS 28-67% MORE ACCURATE THAN OTHER MODELS (at 50 th Percentile) and FREE CASH FLOW AND LCRT INTRINSIC VALUES PERFORM THE BEST TO SEPARATE “WINNERS” FROM “LOSERS” LOG 2 of % Absolute Model Error versus Actual Price - Fiscal Year +3 Months 1994-2002 47 63 79 67 Cumulative % of Universe Sources: Financial Statements and Price Data – CapitalIQ Calculations - LCRT’s Platform Constant Dollar Gross Investment > $100 Million 20,957 Company-Years; 1994-2002; Industrials Sources: Financial Statements and Price Data – CapitalIQ Calculations - LCRT’s Platform Constant Dollar Gross Investment > $100 Million, Panel Data from 1994-2002, 17,697 Company-Years

21. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 21 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform USING THE LCRT DCF MODEL, 57% OF THE APPROVED LIST IS OVER-VALUED AND 72% (100- 28) IS MORE OVER-VALUED THAN THE UNIVERSE Any one of the following three hypotheses could be true: – 1. Approved List may pick more “losers” than “winners” – 2. OR Approved List may pick more “winners” than “losers” – 3. OR Employing both the Approved List and LCRT’s valuation may pick more “winners” than “losers” Empirical Tests to distinguish which Hypothesis of the three is most true – Translate each dimension of the beliefs used to produce the Approved List into testable valuation models – Back test each model’s accuracy and predictive capability – Test combination of Approved List implicit valuation models and LCRT Feedback from the empirical results will improve the stock selection PROCESS Approved List Universe 57 28 = 100 – 72

22. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 22 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform NEXT GENERATION LCRT MODEL (About 70% Complete) single ALL Place all risk and other effects in the cash flows, so a single discount rate applies to ALL firms in each super sector for each year (22,000-115,000+ company-years 1994-2003) Treat equity as an option on the cash economic returns, growth, capital structure, and restructuring potential of the operating assets (using only disclosed historical data to drive the model’s cash flow forecast) – Refine company CER Fade-To’s and Fade Rates to reflect empirical realities across the entire CER spectrum from boundary to boundary, using option and tangent functions – Refine asset growth fade rates to reflect market expectations – Employ an option pricing function to quantify the deadweight loss of bankruptcy – Employ an option pricing function to describe equity and debt holder pressure to sell assets – Divide the intrinsic value employing one uniform discount rate for all firms into its debt and equity components – Describe start-up CER’s with an impulse function

23. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 23 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform FINAL THOUGHTS We practitioners and academics still have a long way to go to improve the robustness & accuracy of DCF valuation models and their predictive capability! – WSJ 9-29-04 page 1 article suggests new model where donor demands 5 best scientists collaborate to find a cure much faster than individually (author’s picks – Tom, Joel, Bennett, Aswath, Ed Altman, RT) Most people assume that tracking errors arise primarily from discontinuities between future cash flow forecasts and historical results. LCRT empirical results strongly suggest otherwise! Stay tuned.

24. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 24 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform BACKUP SLIDES

25. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 25 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE RELATIVE WEALTH CHART STRATEGICALLY COMPARES WEALTH CREATED TO CASH ECONOMIC RETURNS (CER’S) ABOVE THE DISCOUNT RATE AND TO ASSET GROWTH

26. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 26 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE INTRINSIC VALUE CHART COMPARES PRICES TO INTRINSIC VALUES TO DETERMINE IF THE FIRM IS UNDER OR OVER VALUED Notice the large high low variation around the intrinsic valuations, providing opportunity for profitable trading The Absolute “Tracking” Error Intrinsic Value vs. Actual Equals the Absolute Geometric Mean Error Between The Intrinsic Value Red Line And Closing Prices at Fiscal Year + 3 Months (hollow circles) Over the Number of Years

27. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 27 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE PREDICTIVE INTRINSIC VALUE CHART ESTIMATES CONVERGENCE OF ACTUAL PRICE TOWARD INTRINSIC VALUE

28. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 28 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE COMPARATIVE INTRINSIC VALUE CHART COMPARES THE TRACKING ERROR ACCURACY OF TWO MODELS TO DETERMINE WHICH TO RELY ON FOR SELECTING STOCKS LCRT Residual Income

29. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 29 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform THE COMPARATIVE INTRINSIC VALUE CHART ALSO QUANTIFIES VALUE EFFECTS OF NON-RECURRING ITEMS WHICH MAY NOT BE ONE TIME EVENTS

30. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 30 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform ADDING ANALYSTS’ SALES AND EPS ESTIMATES ENABLES COMPARISONS OF PLAN VALUES FROM THE FORECASTS AGAINST SPOT VALUES FROM HISTORY

31. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 31 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform MOST ASSETS PRODUCE A NEARLY LEVEL USEFUL OUTPUT UNTIL FAILURE, INSTEAD OF THE STRAIGHT LINE OR THE DECLINING BALANCE CURVE REFLECTING DEPRECIATED PLANT Output Time (2) Most Assets Produce Nearly Level Output… Until Failure (1) Constant Output = Constant Dollar Level Annuity Economic Life (3) Straight Line Depreciation Net Plant (4) Accelerated Depreciation Net Plant Failure (One Horse Shay) (Economic Value Added Implicit Assumption)

32. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 32 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform CASH ECONOMIC RETURN REFLECTS THE AVERAGE INTERNAL RATE OF RETURN OF ALL THE PROJECTS IN PLACE Cash Economic Return Existing Projects

33. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 33 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform GLOSSARY OF KEY MEASUREMENT TERMS Measurement Types – Maximum of 10 Years – Robustness - % of company years for each firm where the model calculates a valid answer – Ideal is 100% Valid answers can be negative Rates of change (e.g. EPS growth rate) where the divisor is negative are not calculated and treated as zero robustness for that year – Accuracy – geometric mean % error between the model value and the actual value – averaged over 10 years maximum; non- robust company years are excluded; absolute error or signed error as separate measures – like golf, lower scores are better Measurement Applications – Maximum of 10 Years – Explanatory Price Level: Model Price versus Actual Price – Explanatory % Capital Gain Return (CG) – Annual Model CG versus Actual CG Concurrently – Fiscal Year -9 Months to Fiscal Year +3 Months to allow for disclosure lags’ effect on prices – Predictive % Capital Gain (CG) – Annual Predicted Model CG versus Actual CG – Fiscal Year +3 Months to Fiscal Year +15 Months to allow for disclosure lags’ effect on prices

34. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 34 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform A BETTER EXPLANATORY MODEL IS MORE PREDICTIVE R 2 = 0.473 N = 2,752 OLS Least Absolute Deviation LCRT Intrinsic Value Model These results support the intuition of HOLT’s clients, who in the late 1980’s said, “I only employ the model for buy/sell decisions when it tracks well.” “Few strokes separate the best from the worst professional golfers.” Like golf, lower scores indicate more accuracy. This chart violates the instantaneously efficient market hypothesis. It represents an “anomaly” consistent with behavioral finance theory.

35. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 35 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform LCRT ACKNOWLEDGEMENTS (1) “We all stand on the shoulders of giants” Consider receiving the insights and wisdom of radicals in the minority Despite what the communists believe, property rights and democratic rule of law matter (Adam Smith, Karl Marx, F.A. Hayek, Milton Friedman) Despite what the socialists believe, high marginal tax rates seriously reduce freedom, incentives, and economic efficiency (Arthur Laffer) Supply side matters – laws, rules, regulations, and structure significantly impact freedom and economic efficiency (Jude Wanniski) Seek to understand anomalous empirical behavior, especially traditional outliers. Re-evaluate all your underlying assumptions (Thomas Kuhn) The stock market may not be instantaneously efficient (Vernon Smith)

36. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 36 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform LCRT ACKNOWLEDGEMENTS (2) The Central Limit Theorem fails when the underlying distribution does not possess a finite variance. Employ least absolute deviation instead of least squares (Robert Blattberg and Thomas Sargent) Brownian motion fails. Draws from distributions are not independent. Where you start matters. Memory exists in the System and leads to Fat Tailed Stable Distributions instead of Gaussian Normal ones (Benoit Mandelbrot, Edgar Peters) Replacing the Gaussian assumption with a Stable one eliminates option “volatility smiles” (Stanley Miles) The CER Fade-To is not the same for all firms. This imperfect regression toward the mean relates to the starting position, memory in the System, and the underlying fat tailed Stable Distributions (Rawley Thomas) Use an impulse function to describe the life cycle of a start-up firm (George Box, Gwilym Jenkins, Rawley Thomas) The necessary specialization of all professions often breeds a myopic inability for all of us (the author included) to view the panorama of all the patterns affecting life and economic transactions between free individuals

37. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 37 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform LCRT PHILOSOPHICAL RESEARCH INSIGHTS Get the Big Picture Right before Refining the Little Details (LCRT Included) Better to be approximately correct than precisely wrong Permutation production on panel data with binary search on three choices enables narrowing the range of reasonable model parameter values – shortens elapsed research time from years to weeks

38. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 38 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform EMPIRICAL VALUE AUDIT OF VALUATION MODELS Translate conceptual intrinsic value models into testable intrinsic value models, using only disclosed historical data without any analyst overrides or interventions Determine estimation procedures for all company years and model permutations Specify permutations of ranges of company drivers and model parameters to test Program model and planned permutations Select sample Measure robustness as % of company years where the models calculate versus all years Quantify accuracy as the % difference between model intrinsic values and actual stock prices Compare robustness and accuracy to other models with the cumulative % tracking error on the whole sample Measure and compare predictive capability of the models to separate “Winners” from “Losers” as prices oscillate around intrinsic values. Review distributions, deciles, and years. Refine model – Identify anomalies and outliers of the models Graph model errors against key model drivers Over-sample tails of each value driver Review individual firms at the extremes and tails for data errors, algorithm imperfections, and model structural problems – Correct errors, imperfections, and problems – Re-Test models

39. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 39 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform UNDER (OVER) INTRINSIC VALUATION VERSUS CER ILLUSTRATES EMPIRICAL VALUE AUDIT ANALYSIS OF OUTLIERS AND PATTERNS CER Fade-To N = 26,018, 1994-2003 Industrials, C$GI > $100M R 2 = 0.341 MSFT, Yahoo AAPL, GY, AMESQ

40. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 40 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform PREFERRED EMPIRICAL SEQUENCE OF PARAMETER DERIVATIONS IN DCF MODEL SPECIFICATIONS Growth should be ranked 8 th to 9 th in conceptual and empirical importance behind other more important value drivers Proper order for deriving parameters for key value drivers – Cash Economic Return (CER) – Uniform market derived discount rate for all companies for each year – CER Fade-To – CER Fade Rate – Gross Debt to Value of Existing Assets – Deadweight Cost of shifting asset ownership from equity to debt holders - Bankruptcy – Market Value of Debt – Restructuring of Assets Potential – Growth Fade-To – Growth Fade-Rate

41. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 41 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform INDIVIDUAL SECURITY ANALYSIS NATURALLY OCCURS AFTER THE STRUCTURE AND SUPPORTING EMPIRICAL RESEARCH OF THE VALUATION MODEL SPECIFICATION Restatement of historical results to better reflect economic reality Algorithms on such issues as operating lease capitalization, pension funds, post retirement benefits, and executive stock options Override Assumptions Forecast material discontinuities of past and future economic performance based on competitive strategic assessments Compare “spot intrinsic values” from historical data and “plan intrinsic values” from forecasts to current price to quantify under or over valuation

42. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 42 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform SECURITY ANALYSIS PROCESS COMPARISONS TRADITIONAL LCRT Apply Empirically Validated LifeCycle Valuation Model and Market Derived Discount Rate to historical statements to produce “Spot Intrinsic Values” for every year Analyze historical statements to determine if they accurately reflect Cash Economic Returns on operating assets and asset growth rates Analyze historical statements to separate operating from financial cash flows; Compare accounting returns to CAPM costs of capital Beat market benchmarks by purchasing under- valued firms and selling short over-valued firms Forecast cash flows, often from margins and capital turnover Apply perpetuity terminal valuation (NOT Empirically Validated) to forecast to produce “Plan Intrinsic Value” Forecast free cash flows, often from margins, capital turnover, and estimated CapEx Apply LifeCycle terminal valuation to forecasts to create “Plan Intrinsic Value” Compare “Plan Value” from forecast to current price Compare “Spot Historical Intrinsic Values” and “Plan Intrinsic Value” from forecast to current price

43. © 2004 LifeCycle Returns, Inc. All Rights Reserved - 43 - Sources: Financial Statements and Price Data – CapitalIQ Calculations – LCRT Platform LCRT PERCEPTION: STRATEGIC POSITIONING AND EMPHASIS ON INDIVIDUAL FIRM SECURITY ANALYSIS VERSUS VALUATION AND STOCK SELECTION QUANTITATIVE MODELS Zacks, First Call Morgan Stanley Merrill Lynch CSFB HOLT LifeCycle Returns Schwab Retail “Sweet Spot” ? Hypothesis: Moving from heavy individual security analysis in the upper left toward more model based valuations in the lower right may enable the security analysis function to add more value and become more scaleable, IF the valuation model employed is more robust, accurate, and predictive. Analysts spend more time on material valuation issues and strategic forecasts.