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Equity Market Valuations LAPERS Fall Seminar September 17, 2013 Presentation by Dr. Bhaskaran Swaminathan, PhD Partner and Director, Research LSV Asset Management

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Agenda Motivation Popular valuation measures An intrinsic value based approach Predicting Market Returns Implications and conclusion 2

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Motivation How do we determine if a given stock or the overall market is currently undervalued, overvalued or fairly valued? Popular measures of valuation: ◦ Dividend-to-Price ratio (D/P), Earnings-to-Price ratio (E/P), Book-to-Market ratio (B/M), EBITDA-to- Enterprise value ratio (EBITDA/EV). ◦ High values indicate undervaluation. Earnings, Dividends, Book, etc. are proxies for intrinsic/fundamental value (V). 3

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What is intrinsic value? The intrinsic value is the present value of expected future free cash flows discounted at a risk-adjusted cost of capital: In efficient markets, Price (P) = Intrinsic Value (V). If markets are not efficient, then Price doesn’t have to equal Intrinsic Value. If (V > P), the security is undervalued; if (V < P), the security is overvalued, Graham and Dodd (1934). In practice, we use accounting variables such as earnings, operating income, book, etc. as proxies of (V). 4

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Dividend-to-Price (D/P) Ratio Aggregate dividends divided by aggregate market capitalization (also referred to as dividend yield). Widely used to predict market returns in academic studies: ◦ Fama and French (1988) Since the 1980s, firms have substituted stock repurchases for dividends. Perhaps misleading to compare current D/P to historical D/P. 5

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Forward Earnings-to-Price (FY1/P) One-year ahead analyst earnings forecasts divided by aggregate market capitalization. It incorporates expected future earnings growth rates and, therefore, reflects current economic expectations. On the other hand, it is still an annual measure which can be cyclical and noisy. 7

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Shiller’s 10-year Average Earnings- to-Price Ratio (E10/P) Since annual earnings are cyclical and noisy, Campbell and Shiller (1988) propose a trailing 10-year average earnings-to-price ratio, E10/P. It is just the inverse of Shiller’s cyclically adjusted P/E (CAPE) measure. 10-year average earnings is likely to be more smooth and arguably a better measure of fundamental value than 1-year earnings. On the other hand, it is backward looking and can be heavily influenced by one negative event. 9

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EBITDA-to-Enterprise Value Aggregate EBITDA divided by Enterprise Value. EBITDA = Earnings Before Interest and Taxes (EBIT) + Depreciation & Amortization (DA). EBIT+DA=EBITDA. EBITDA represents the operating cash flows of a company and is less noisy than Earnings although it is also a one-period measure. Enterprise value is the sum of market value of equity, debt, and preferred stock less excess cash. 11

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Book-to-Market (B/M) Ratio Aggregate book value of equity divided by the market value of equity. The book value of equity is another measure of fundamental value. Unlike annual earnings, book is the sum of all past retained earnings and hence is a smoother measure than earnings. Book value, however, excludes the value of intangible assets and could underestimate the fundamental value of growth companies. 13

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Is there a better way? All these measures use very noisy proxies of intrinsic value. And, each measure has its own problems. And, they do a poor job of predicting future returns Can we do better? Can we use intrinsic value models? How would intrinsic value models fare in comparison to these valuation ratios? 15

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Intrinsic Value Approach The discounted cash flow model can be used to directly estimate the intrinsic value of a stock: Lee, Myers and Swaminathan (1999) estimate the intrinsic value of the Dow 30 stocks using analyst earnings forecasts and show that a Value-to-Price (V/P) ratio predicts future market returns better. The difficulty is in estimating the cost of equity r e. 16

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Implied cost of capital (ICC) Instead, estimate the cost of equity (r e ) from the intrinsic value model by setting, Price = Value: r e is the internal rate of return (IRR) that equates the present value of future cash flows to current stock price;. Like the yield to maturity (YTM) on a risk-free bond. In efficient markets, P = V, and r e should represent the rational expected return. If markets are not efficient, r e will be too high for undervalued stocks and too low for overvalued stocks. 17

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Implied cost of capital Academic papers using this approach: ◦ Average risk premium: Claus and Thomas (2001), Fama and French (2002); ◦ Cross-sectional asset pricing (betas and characteristics): Kaplan and Ruback (1995), Botosan (1997), Gebhardt, Lee, and Swaminathan (2001), Easton and Monahan (2005); ◦ International asset pricing: Lee, Ng and Swaminathan (2009); ◦ Default risk and expected stock returns: Chava and Purnanandam (2010); ◦ Time-series: Pastor, Sinha, and Swaminathan (2008) on inter-temporal risk- return trade-off. Li, Ng and Swaminathan (2013, forthcoming, Journal of Financial Economics) use this approach to compute a forward looking risk premium measure for the S&P

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Two reasonable economic assumptions A firm cannot grow faster than the economy forever: ◦ Earnings growth rates should converge to the nominal GDP growth rates in the long run. Competition drives economic profits to zero: ◦ The return on new investments (ROI) should converge to the cost of capital in the long run. 19

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How do we compute the ICC? Divide the infinite horizon model into 2 parts: T=15, ‘FE’ is the forecasted earnings and ‘b’ is the plowback rate. ICC is based on forward-looking smoothed cash flows. ‘ 20

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How do we compute the ICC? Use analyst forecasts of earnings FY1 and FY2. Assume the growth rate implicit in the two forecasts, g2=FY2/FY1-1, mean-reverts to the nominal GDP growth rate by Year 15. Use these growth rates to project future earnings. Plow back rate = 1 – Payout Ratio. Set plowback rate for Year 1 equal to last year’s plowback rate. Mean-revert the plowback rate to a long-term value by Year 15. Estimate future cash flows and compute the ICC for every firm in the S&P 500 from January 1977 to September Value-weight individual ICCs to obtain the ICC of S&P 500. Subtract the yield on the 1-month Treasury Bill or the 30- year Treasury Bond to compute the implied risk premium. 21

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How do these measures predict future market returns? In the paper, we examine how these various measures have performed in predicting market returns over the next 4 years. I will present the results for predicting the next 3-year returns. Regression: R3YR = a + b*X ‘R3YR’ is the dependent variable and ‘X’ is the independent variable. ‘a’ is the intercept, ‘b’ is the slope coefficient. X = D/P, E/P, B/M, E10/P or ICC. 24

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25 T-statistic measures statistical reliability. T-statistic > 2 indicates there is 95% confidence in the results. R-Square measures how much of the variation in next 3 year returns is explained by the independent variable X. ICC is the risk premium with respect to 1-month T-bill. Only ICC predicts future returns in a statistically significant manner. Predictability Findings

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Conclusions Popular measures of market valuation all suffer from various conceptual problems. ICC is a theoretically superior approach that relies on discounted cash flow models and is based on smoothed forward-looking cash flows. It is also an empirically superior measure that has the best predictive power for market returns over the next three years. The methodology can also be used to estimate style premium between Value and Growth, Low Volatility and High Volatility etc. 26

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