Research Firm Details

Focus on Valuation: Cash flows are influenced by the firm's operations (e.g., profits, expansion and contraction plans), use of debt and its resulting tax implications, dividend policy, and ability to adjust to changes in inflation. In practice, judgments about these determinants of cash flow can be distilled to just two key forecasts: return on investment (ROI) and asset growth. Ativo Research defines these variables in a manner that reflects underlying economic realities, rather than accounting conventions. In contrast with a firm's inflation-adjusted total assets, the ROI measure incorporates cash flow rather than earnings. The growth forecast (real growth in total assets) determines cash requirements for future investments. These investments will in turn eventually generate additional cash at a rate determined by the ROI earned by the firm.

The Ativo Research valuation model converts the ROI and asset growth forecasts into a stream of net cash flows extending over several decades. Over time, these cash flows are adjusted to reflect longer-term economic trends. High ROI companies attract competition, which eventually erodes the ROI they are able to earn. Companies with below average ROIs find themselves either out of business or with new management.

The other major variable in the valuation equation is the discount rate (or cost of capital) that is applied to the net cash flows. This will ultimately determine the total value of the firm and, after an adjustment for the debt and shares outstanding, determine the value of each share.

While cash flows, ROIs, and growth rates are generally understood (and to some degree controllable) by management, the discount rate, also known as cost of capital (COC), is set by the holders of the firm's securities. Therefore, the major factors influencing the firm's discount rate include the security-holders' pretax requirements for income from dividends, interest, and capital gains. The prevailing discount rate is greatly affected by incremental tax rates and changing inflation expectations, which also affect the embedded tax premiums.

The Importance of the Cost of Capital: Ativo Research calculates the cost of capital in two ways. The first method of estimating COC produces what is called the equilibrium or warranted cost of capital. This approach calculates the nominal pre-tax return an investor needs to earn a real, after-tax pure rate of return on his/her investment. This pure rate of return, which Ativo Research estimates to be about 3%, is tied to long-term GDP growth and the marginal productivity of capital. The specific Equilibrium COC derived using this approach is a function of this pure rate of return, inflation, marginal tax rates, dividend yield, and expected capital gains.

The second approach to determining COC is empirical. As described above, Ativo's valuation model calculates stock prices as a function of ROI and asset growth forecast, whose outcome is a stream of cash flows to be discounted at the cost of capital. Although ROI and growth forecasts for specific companies vary significantly, ROI and growth for the market as a whole (S&P 500) are relatively stable. Since the current ROI, growth, and today's price are known quantities. Ativo simply solves the model backwards to determine the prevailing cost of capital.

For over four decades, both methods produced similar results for extended periods of time, lending credibility to both estimates. When the methods differed, the gap between them, generally less than 250 basis points, preceded important long-term market moves. In the late sixties and early seventies, the equilibrium rate rose on accelerating inflation and higher tax rates, while the prevailing rate continued at previous low levels. The market then declined 25% (in real terms) in 1969/1970 and nearly 50% in 1973/1974 as the market adjusted and the prevailing cost of capital finally caught up with the equilibrium rate. Likewise, the great bull market of the 1980s/1990s was associated with a falling cost of capital as moderating inflation and lower tax rates brought down the equilibrium rate.

The cost of capital is a critical variable affecting investment decisions. From a corporate perspective, when a firm is able to earn a return in excess of its cost of capital, investment adds value, and the firm grows. When a firm earns less than its cost of capital, incremental investment destroys value, and the firm is forced to contract. At a 7% cost of capital, just over half of US firms create value by expanding, while a 6% cost of capital means that roughly two thirds have an incentive to expand.

Investment Process: Fundamental accounting data is collected from 10Qs, 10Ks, and other regulatory filings. The data provider performs an initial data scrubbing and standardization. Then, consensus earnings estimates and asset growth forecasts, for the next five years, are collected from the market place. Information on daily prices, splits, dividends and other distributions is gathered daily.

On a weekly basis, the Ativo system computes the accounting adjustments for 9,000 firms. Key statistics computed are Current Cost Gross Assets, Average Asset Life, Discounted Cash Flow ROI, Current Cost Return on Net Assets and Tobin's Q Ratio.

The adjusted fundamental data is combined with the consensus estimates to explicitly forecast the Balance Sheet and the Income Statement for the next 5 years, and then the schedule of Net Cash Receipts for the following 30 years. The future cash flows and the current stock price indicate what discount rate the market is currently employing to value each stock. That implied discount is compared with each firm's fundamental discount rate to determine if the stock is currently over- or under-priced. This information combines with other measures of attractiveness to determine the overall rating. At each step, quality control measures are designed to catch errors before they propagate. The final ranking changes are reviewed one more time, to ensure reasonableness.