Model Architecture
We use simple models, using a limited number of input variables and simple mathematical patterns to describe alternatives for future performance (cf. Arnold Zellner, Keep It Sophisticatedly Simple, KISS).
Value Drivers
We mainly use time series of book value and earnings per common share. Many companies (in their financial reports) and market professionals (in their research and analyses) refine and adjust these or related metrics (e.g., by normalizing for unusual or non-recurring items, focusing on realized or cash gains as opposed to accounting earnings and equity, adjusting for inflation where corporate accounts do not, etc.); we sometimes also make ad hoc adjustments where we think these are helpful, but in general are convinced that most aspects of valuation can be addressed by using long-run and standard definitions of book value and earnings per common share.
Discounted Cash Flows
We believe markets over the long run and on average discount future cash flows and take into account the relationship between return on capital and cost of capital; we calculate intrinsic value of companies accordingly.
Future Performance
We model future corporate performance in the form of simple alternative patterns that are realistic or may realistically be embedded by reasonable investors. Generally, we ask what corporate value would be if long-term performance would follow a number of different assumed patterns:
- Cyclical variation in line with normal business cycles
- More volatile oscillation within historical extremes of corporate performance.
- Gradual approach of an equilibrium level
- Combinations of these
During normal times we have a preference for determining value under the assumption of recurring normal business cycles, but believe that under certain market conditions or in certain situations other alternatives may closer reflect market and investor expectations. Therefore, our ultimate view on value is the result of probabilistically and qualitatively weighing the different outcomes against prevailing market conditions.
The recent upheavals in the financial industry lend support to an analytical approach that quantifies the value impact of banks' deteriorating operating performance, its likely recovery and the repetition of these cycles in the future.
Top Down
Our approach is “top down”, i.e., we use the same approach with limited adjustments (e.g., for the cost of capital) for financial companies of different size, location of headquarter or operations, etc. The main “differentiating inputs” we use relate to individual past and current performance and current market prices. We do follow and read “bottom up” research to put what we derive from our models in a qualitative context but generally prefer our stylized models to interpret market action and analyze investor expectations.
