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Summary of Bank of America Merrill Lynch's Global Equity Valuation Approach

Core Content

This report outlines Bank of America Merrill Lynch's updated approach to company financial valuation and analysis using the iQ method, a systematic framework designed to ensure consistency and transparency in global equity research. The iQ method is part of a broader suite of iQ analytics tools, aimed at providing investors with detailed, structured, and reliable financial data for decision-making.

Main Viewpoints

• The iQ method is a structured, detailed, and transparent approach that supports global valuation and analysis.
• It focuses on three broad categories: Business Performance, Quality of Earnings, and Valuation.
• The method includes over 16 standard measures and a comprehensive iQ database with more than 2,500+ stocks and 100+ detailed line items.
• The framework is designed to identify common valuation pitfalls and ensure consistent interpretation of financial metrics.

Key Information

1. Business Performance

This section evaluates how effectively management is deploying capital within the enterprise. Key metrics include:

• Return on Capital Employed (ROCE): Measures the return on capital used in the business. It is calculated as:

  • Numerator: NOPAT = (EBIT + Interest Income) * (1 - Tax Rate) + Goodwill
  • Denominator: Total Assets - Current Liabilities + Short-Term Debt + Accumulated Goodwill Amortization
  • Units: %
  • Note: ROCE is based on an after-tax approach, and the denominator should reflect the average capital employed rather than just the year-end value.

• Return on Equity (ROE): Measures the return to equity holders. It is calculated as:

  • Numerator: Net Income
  • Denominator: Shareholders’ Equity
  • Units: %

• Operating Margin: Indicates pricing power and cost control. It is calculated as:

  • Numerator: Operating Profit
  • Denominator: Sales
  • Units: %

• EPS Growth: Reflects expected future earnings growth. It is based on a 5-Year CAGR from the latest actual earnings.

• Free Cash Flow: Measures the cash available to the company after all capital expenditures. It is calculated as:

  • Numerator: Cash Flow From Operations - Total Capex
  • Units: Mn

2. Quality of Earnings

This section assesses the sustainability and security of a company’s earnings. Key metrics include:

• Cash Realization Ratio: Compares cash flow from operations to net income. It is calculated as:

  • Numerator: Cash Flow From Operations
  • Denominator: Net Income
  • Units: X

• Asset Replacement Ratio: Measures the ability of a company to replace assets. It is calculated as:

  • Numerator: Capex
  • Denominator: Depreciation
  • Units: X

• Tax Rate: Reflects the proportion of pre-tax income that is paid in taxes. It is calculated as:

  • Numerator: Tax Charge
  • Denominator: Pre-Tax Income
  • Units: %

• Net Debt/Equity Ratio: Compares net debt to total equity. It is calculated as:

  • Numerator: Net Debt = Total Debt - Cash & Equivalents
  • Denominator: Total Equity
  • Units: %

• Interest Cover: Measures the ability of a company to meet its interest obligations. It is calculated as:

  • Numerator: EBIT
  • Denominator: Interest Expense
  • Units: X

3. Valuation

This section connects a company's economic performance with its market value. Key metrics include:

• Price/Earnings Ratio (P/E): Reflects the payback period of the company's earnings. It is calculated as:

  • Numerator: Current Share Price
  • Denominator: Diluted Earnings Per Share
  • Units: X

• Price/Book Value: Compares the market value of equity to its book value. It is calculated as:

  • Numerator: Current Share Price
  • Denominator: Shareholders’ Equity / Current Actual Shares
  • Units: X

• Dividend Yield: Reflects the return from dividends. It is calculated as:

  • Numerator: Annualized Declared Cash Dividend per Share
  • Denominator: Current Share Price
  • Units: %

• Free Cash Flow Yield: Reflects the potential return from free cash flow. It is calculated as:

  • Numerator: Free Cash Flow
  • Denominator: Market Cap. = Current Share Price * Current Actual Shares
  • Units: %

• Enterprise Value/EBITDA (EV/EBITDA): A structure-neutral multiple that reflects cash generation. It is calculated as:

  • Numerator: Enterprise Value = Market Cap. + Net Debt + Other LT Liabilities
  • Denominator: EBIT + Depreciation + Amortization
  • Units: X

• Enterprise Value/Sales (EV/Sales): Reflects volume leverage. It is calculated as:

  • Numerator: Enterprise Value
  • Denominator: Sales
  • Units: X

4. iQ Analytics Tools

• iQ toolkit: Offers sector and regional analysis via MLX web portal, Bloomberg, and soon Reuters platforms.
• iQ Works: Enables custom reports and charts, including user-defined ratios and calculations based on detailed data from the iQ database.

5. Limitations and Considerations

• The ROCE may be distorted by the age of assets and should be adjusted using replacement cost.
• Cash-based ROCE (CROCE) is a more accurate measure of economic returns, incorporating inflation and depreciation.
• WACC (Weighted Average Cost of Capital) is a critical metric for evaluating the economic return. It is based on three components: Risk-Free Rate, Equity-Risk Premium, and Beta.
• Balance sheet valuations can differ from open market values, especially for regulated utilities, real estate companies, and post-reconstruction enterprises. These differences can overstate ROCE.

6. Outliers and Interpretation

• Companies with high Economic Returns and low MVAs may be undervalued.
• Companies with low Economic Returns and high MVAs may be overvalued.
• The Rating of Economic Profit (REP) is a single-number metric that compares Enterprise Value/Capital Employed with ROCE/WACC.

7. Key Principles

• The iQ method is based on prudence, consistency, and transparency.
• Metrics should be relevant, simple, applicable across sectors, and forecastable.
• The method emphasizes cash flows, quality of earnings, and economic returns over purely accounting measures.

Conclusion

The iQ method provides a robust, systematic, and transparent approach to global equity valuation, with a focus on economic performance, earning quality, and market alignment. It enables investors to make more informed decisions by offering a comprehensive set of metrics, clear definitions, and tools for data manipulation and analysis.