Global Economics Paper No: 179

Goldman Sachs Global Economics, Commodities and Strategy Research at https://360.gs.com

Finding Fair Value in Global Equities: Part I

A Valuation Anchor for Equities: We introduce GS DDM, a new approach to valuing equity markets globally We take three approaches to fair value: 1) Fair Value under our current central assumptions, applying current bond yields and estimated ERP. 2) Fair Value adjusted for current fair value bond yields using our Sudoku bond model. 3) Equilibrium Value, assuming the ERP and bond yields revert to long run averages. The model 1) is estimated in the same way in each major region to establish a benchmark for fair value; 2) lends itself to reverse engineering assessing what assumptions the market is implying. We look at the sensitivity of fair values to changes in the underlying assumptions. In our forthcoming Part II, we will extend this analysis to forecast the ERP and market levels. Our analysis shows that, using current central assumptions, most markets are undervalued by between 3% and 15% with Europe the most undervalued. Using our fair value Sudoku bond yield assumptions instead of current yields increases the undervaluation in all regions. In all cases, an assessment of equilibrium valuation, based on assuming the ERP reverts to a long run average and using a long run trend real yield of 2% shows substantial undervaluation of 71% for Europe, 36% in the US, 31% in Asia ex Japan and 13% in Japan.
Important disclosures appear at the back of this document

This Global Paper was prepared by Peter Oppenheimer, Jessica Binder and Anders Nielsen

Jim ONeill, Peter Oppenheimer, Kathy Matsui, Tim Moe, David Kostin and Dominic Wilson February 6, 2009

Goldman Sachs Global Economics, Commodities and Strategy Research

Global Economics Paper

Summary
We introduce a 4-stage dividend discount model that is estimated in the same way in each major region. This is used as a valuation anchor for international comparison. In generating results from GS DDM, we have taken three approaches. 1) Fair value today using our central scenario (how should we think of equities relative to current bond yields?). 2) Fair value today using fair value bond yields, based on our Sudoku model (how should we think of equities assuming bonds were fairly valued in the current environment?). 3) Equilibrium value using long run average real bond yields and ERP (how much of the current valuation gap is due to the fact that the discount rate is higher/lower than normal?). We estimate that the upside to fair value given the current economic environment and bond yields is, 15% in Europe, 11% in the US, 4% in Asia ex Japan and 3% in Japan. Adjusting the fair value for current fair value bond yields increases the undervaluation in all equity markets. On a long run Equilibrium Value basis we find an upside to fair value of 71% in Europe, 36% in the US, 31% in Asia ex Japan and 13% in Japan. We estimate the upside to long run equilibrium fair value by using a real interest rate of 2% and an equity risk premium of 3% (except in Asia ex Japan where we use 4%) in our dividend discount model. Chart 1 shows that the deviation of market values from long run equilibrium levels tend to close over time. One percentage point of additional upside to fair value at the beginning of the year on average increases the total return during the year by 0.3 percentage points (Chart 2). Chart 2 also shows that the upside to fair value explains 15% of the variation in yearly returns.
Table 1: GS DDM Fair-value and equilibrium levels
Central Scenario Current Level 846 195 786 266 Fair Value Level 941 224 809 277 Fair Value Upside / (Downside) 11% 15% 3% 4% Using Sudoku Fair Value Bond model Fair Value Level 943 274 916 NA Fair Value Upside / (Downside) 12% 41% 16% NA Using equilibrium ERP* and 2% real interest rate Fair Value Level 1152 333 886 349 Fair Value Upside / (Downside) 36% 71% 13% 31%

US (S&P 500) Europe (Stoxx 600) Japan (TOPIX) Asia (MSCI APxJ)

Source: Goldman Sachs Global ECS Research

Chart 1: S&P 500 reverts to fair value over time

60% 40% 20% 0% -20% -40%

Chart 2: Deviations from fair value predicts returns

50

Overvalued

Return over the next year (%)

40 30 20 1 0 0 -1 0 -20 -30 -40 -50 -60 -40 -20 0

y = 0 .3 19 7 x + 9 .2 16 2 R 2 = 0 .14 5 7

Undervalued
-60% Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07

20

40

Ups ide t o lo ng run f a ir v a lue ( %)

Source: Goldman Sachs Global ECS Research Issue No: 179

Source: Goldman Sachs Global ECS Research

February 6, 2009

Goldman Sachs Global Economics, Commodities and Strategy Research

Global Economics Paper

Finding a fair value anchor for equities; Introducing GS DDM

Valuing equity markets is always controversial because any chosen approach relies on assumptions. Equally, valuation is not the only driver of markets. Markets can stay above or below theoretical fair value for long periods of time. Nevertheless, using a standard, easily comparable, valuation model that provides an anchor to fair value and can be used to compare across markets can help to identify opportunities and risks; it can also be used as a forecasting tool. At the very least, it might also shed some light on the kinds of assumptions that implicitly need to be made in order to justify deviations from equilibrium valuation over time. Across the regions, GS Strategists use a variety of different tools and measures to assess value. The importance given to any particular approach varies by region and over time, according to the structure of the market and the stage of the cycle. Our interest here was not to replace these models but to supplement them with a single approach that can be applied globally, providing a guide to fair value using an assessment of current drivers and also as a guide to equilibrium the fair value level of the market assuming that the Equity Risk Premium converges to the long run average and real bond yields are at their long run trend.

Two approaches to valuation

We introduce a common basis for the global valuation of equities with GS DDM (dividend discount model). In each region, we monitor and forecast with several different types of valuation tools. These include earnings based multiples (cyclically adjusted), dividend and free cash flow yields, book valuations, relative valuations against competing assets and a number of other approaches. For each market we also have a dividend or earnings discount model. However, many of these models are used as a guide to valuing the market in isolation at any time, rather than to compare across markets or focus on an intrinsic fair value. Across the Global Economics, Strategy and Commodities Research Group (ECS) we have, over time, developed a number of valuation tools intended to generate a measure of equilibrium value for each asset class. These can be thought of not so much as a specific forecast for a market but more as a valuation anchor. The advantage of these is that they can provide useful warning signals when markets become very stretched relative to the underlying fundamentals. Furthermore, they provide a framework for understanding what kinds of assumptions investors would need to make at any time to justify current market levels if they are significantly away from fair value. These models include our Sudoku model for the bond markets and GSDEER for foreign exchange markets. In this paper we highlight a new dividend discount model approach that we have developed with the aim of providing an internationally comparable valuation anchor for equities. In effect there are two approaches to equity valuation models, both of which we introduce in a new approach to valuing equity markets globally. A fair value approach: by fixing specific inputs, such as the equity risk premia, one can back out a fair value; this approach is helpful in providing a valuation anchor. A forecast approach: using a fair value to generate an expected future price level.

We introduce a common basis for the global valuation of equities with GS DDM

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Valuation as a fair value guide Our intention in this paper, Part I of a two part series, is the following. To have a model that is estimated in the same way in each major region so that a consistent benchmark for fair value can be established. In this way we can compare valuations across regions and also relative to history. Develop an approach that lends itself to reverse engineering assessing what assumptions the market is implying. This can be particularly useful at turning points or periods when the market appears to have deviated materially from fair value. If a market appears expensive, then what kinds of assumptions would be required in order to justify such valuations? To generate an assessment of Fair Value for the market by applying assumptions about it (bond yields, ERP, earnings etc). To establish an Equilibrium Level level for the markets by assessing the fair value assuming that the ERP converges to a long run average level and real bond yields are at their long term trend. Valuation as a forecast tool The forecast returns approach attempts to assess how quickly the convergence of prices to fair value is likely to happen. In a separate report, Part II of our Valuation series, we intend to invert the fair value model presented in this paper to back out the ERP required to equate market levels to the theoretical fair value. By doing this at different points in time we generate a time series of the implied equity risk premium. We then analyze the relationship of the premium with macroeconomic variables, allowing us to forecast the ERP and, therefore, market levels.

We approach valuation from a fair value angle and as a forecasting tool

Setting out the framework

We considered several valuation approaches to find the one that might be useful for this exercise. One distinction when comparing valuation tools is whether to value the equity or the enterprise value, another is to consider models based on cash flows, returns or multiples. Cash flow models focus on cash flow to equity holders dividends or flows to equity and debt holders free cash flow. Returns models focus on the capital stock and the spread between the return and the cost of capital. For the purposes of this exercise we focus on equity holders and are interested in a discount model rather than a multiple model so that we can more easily test assumptions and scenarios when markets deviate from equilibrium. It is for this reason that we settled on a DDM approach. The model that we have chosen covers the US (S&P 500), Europe (DJ Stoxx 600), Japan (TOPIX) and Asia (MSCI Asia-Pacific ex Japan). The model is based on four phases and assumes that a proportion of earnings are paid out each year as dividends. The length of the phases and the proportion of value for the S&P 500 index that falls in each phase are given in Chart 3.
Chart 3: Model time line
Phase I Phase II Phase III Phase IV

Financial years % of total value

1&2 5%

3&4 5%

5 to 20 23%

Beyond 20 67%

Time

Source: Goldman Sachs Global ECS Research

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Phase I: Forecast growth years 1 and 2 We use our top-down estimates for operating earnings growth for year 1 and year 2. For each year, we adjust the previous years payout ratio by a factor that relates to the forecast growth rate (for example if earnings are expected to rise rapidly, we assume that last years payout ratio falls moderately as dividends are more stable than earnings). Phase II: Fade to trend ROE years 3 and 4 We assume that the market gets back to trend ROE by the end of year 4 and that the earnings change to achieve this occurs equally over the two years. In a normal part of the cycle this may not result in very different growth in earnings from an average year but at major turning points it could result in quite a large jump in growth in either direction. Having an assumption that gets back to a long-term trend is important. Without it, for example, a model could imply ongoing growth from an unsustainably high (or low) level following a boom (or collapse) in profits. Growing from an unsustainable high or low level of profits would alter the implied fair value materially. Phase III: Long-term growth rate years 5-20 We assume that profits grow at their trend rate of growth (equal to the longterm real economic growth rate plus inflation) but assume that the proportion paid out by companies over this period equals the average of the past 5 years. Phase IV: The terminal value We assume that any profits growth in perpetuity is offset by a commensurate change in the payout ratio; this way we ensure that the return on equity is equal to the cost of equity and profits grow in line with trend real GDP. Other key assumptions for current fair value In order to calculate a fair value, we also need estimates for the following. Risk-free rate: We use the current 10-year bond yield for each of the regions (for Asia we use a cap-weighted average). Inflation: We have settled on a 5-year moving average of core inflation as the most stable and consistent measure of expected future inflation that is easily measurable in each region. ERP: While we intend to model the ERP separately in our valuation forecast paper, we cannot use the results of that model as an input into the DDM because it becomes circular (the DDM fair values are used to extract the historical series of ERP). Consequently, we are constrained to making an assumption for the ERP in this model. This is an important limitation since we cannot observe the required ERP directly at any time. For the purposes of our central assumptions used in our assessment of current fair value, we make an assessment about the current appetite for risk, and chose an ERP by reference to the long run ERP series from our ERP model (to be discussed in detail in a follow up report). Currently, for example, we use an ERP of 5% for the developed markets and 6% for Asia, which is in the top quartile of the historical distribution. While changing the assumption for the ERP can make big differences to the output of the model, we examine the sensitivities to these assumptions later in this report. While we do make an assumption about the ERP for our central case assessment of fair value, we also assess the equilibrium level of the market by assuming the ERP and real bond yields are at their long run average.

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All the assumptions are summarized in Table 2:

Table 2: Summary of assumptions for our central scenario
US (S&P 500) Earnings FY1 FY2 FY3 FY4 Payout Ratio FY1 FY2 FY3 FY4 Year 5-20 ROE Long term Inflation Real Growth 10 year bond ERP -5% 31% 3% 3% 41% 38% 39% 40% 32% 14% 2% 3% 3% 5% Europe (Stoxx 600) Japan (TOPIX) Asia (MSCI APxJ) -16% 8% 3% 3% 54% 54% 56% 58% 41% 13% 2% 3% 3% 5% -37% -3% 9% 8% 67% 48% 43% 39% 34% 6% 1% 2% 1% 5% -15% 17% 5% 5% 40% 38% 38% 38% 35% 15% 4% 4% 5% 6%

Source: Goldman Sachs Global ECS Research

Technical Appendix. The DDM V =

t =1 4 20 POt * Et POIM * E4 * (1 + RGDP + INFL)t 4 + + TV (1 + ERP + r10 )t t =5 (1 + ERP + r10 )t

Where

TV = =
And

1 POS * E20 * (1 + RGDP)t 20 (1 + ERP + r10 ) 20 t =21 (1 + ERP + r10 INFL)t 20

1 E20 * (1 + RGDP) 20 (1 + ERP + r10 ) ( ERP + r10 INFL)

V is the fair value.

Et is earnings in period t. For period 1-4, these are Goldman Sachs Strategists forecasts. For t>4,
Et = E4 * (1 + RGDP + INFL ) t 4

PO1 , PO2 , PO3 and PO4 are payout ratio forecasts, based upon the trailing payout ratio adjusted for expected
future earnings growth. ERP is the Equity Risk Premium.

r10 is the 10 year government bond yield.

RGDP is expected long run real GDP growth. INFL is the expected long run inflation rate.

POIM is the intermediate term payout ratio. We use the trailing 5 year average payout ratio.
POS = 1
Issue No: 179

RGDP ERP + r10 INFL is the sustainable payout ratio in real terms.
6

Source: Goldman Sachs Global ECS Research February 6, 2009

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What the model says now

In generating results from GS DDM, we have taken three approaches. 1. Fair Value today using our central scenario Suppose the bond markets are right and the ERP is where we think it belongs in this kind of environment, where would you expect fair value for stocks to be? (How should we think of equities relative to current bond yields) 2. Fair Value today using fair value bond yields (based on our Sudoku model) Suppose the bond markets are themselves at fair value and the ERP is where we think it should be, where would you expect fair value for stocks to be? (How should we think of equities assuming bonds were fairly valued in the current environment) 3. Equilibrium Value Suppose the discount rate (both the real bond yield and ERP) was at its average historical level, where would you expect fair value for stocks to be? (How much of the current valuation gap is due to the fact that the discount rate is higher than or lower than normal).

We have taken three approaches

Fair Value under central scenario

Taking the final results form our model, explained in more detail below, the fair value central scenario levels and percentage upside currently are shown in Table 3. All four markets are trading below fair value but the upside is limited. This is because the valuation is taking into account the current weak economic environment by using an equity risk premium of 5% for all markets except Asia ex Japan, where we use 6%. The upside to fair value is substantially higher if economic assumptions consistent with long run equilibrium are used. Under such assumptions the upside to the European market is 71% for example (see further discussion of this below). This analysis is in line with other work from Goldman Sachs strategists, where we have argued that markets are currently attractively valued but that other criteria are needed to be satisfied in order for that value to be unlocked. Specifically, risk premia need to be reduced. In recent work, many of our strategists have written about conditions that may need to change in order for the long term fair value to be unlocked in a sustained recovery. We believe three key criteria are the following. Evidence that economic activity is stabilizing. In this regard we focus on our proprietary indicators such as the GLI and the Financial Conditions Index (as a measure of policy efficacy) as a guide to a shift in the first and second derivative of growth.

1) Fair value today; our central scenariousing current bond yields and estimated current ERP

Table 3: DDM equity fair value based on central scenario

Current Level 846 195 786 266 Fair Fair Value Value Upside / Level (Downside) 941 11% 224 15% 809 3% 277 4%

US (S&P 500) Europe (Stoxx 600) Japan (TOPIX) Asia (MSCI APxJ)

Source: Goldman Sachs Global ECS Research

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Global Economics Paper

We also expect to see evidence of the market absorbing disappointing data, both macro economic and company specific, without a negative price reaction. We have argued that an improvement in the credit markets is also required as a prerequisite for a sustained recovery in equities since, on a risk adjusted basis, parts of the credit market have overshot fair value even more than equities (see for example our report of November 14, 2008, Strategy Matters: Credit versus equity: Credit offers better value). Again, in this regard, recent improvements in our Financial Distress Index are also encouraging.

Fair Value, adjusting for Sudoku fair value bond yields

One of the issues that may affect the current fair value of equities is the bond yield. In the central case assumptions that we have used in the fair value levels shown in Table 3, we applied the current 10-year bond yields as our risk free rate. In practice this gives some advantage to the US where real rates are much lower. Some investors argue that it is the bond market that is mis-priced (particularly given growing supply risk) and that this distorts equity valuation measures that use the bond yield as an input. Our bond strategists do not believe this to be the case (see Bond Snapshot January 26, 2009) but as a cross check, we also show the current equity fair values, based on our fundamental assessment of fair value in the bond market using the results of our Sudoku bond fair value model. While we do not have estimates for Asia, the conclusions are broadly the same for equities in general: equity markets are currently attractively valued. Europes fair value upside, in particular, rises sharply to 30% when we apply our fair value bond estimates.
Table 4: DDM equity fair value based on Sudoku bond model
Current Fair Value Sudoku Fair Value Bond Upside / Bond Upside / Yield (Downside) Yield (Downside) US (S&P 500) 2.9% 11% 2.9% 13% Europe (Stoxx 600) 3.5% 15% 2.6% 30% Japan (TOPIX) 1.3% 3% 0.9% 16% Asia (MSCI APxJ) 4.9% 4% NA NA
Goldman Sachs Global ECS Research

2) Fair value today using fair value bond yields from our Sudoku model and current estimated ERP

Appendix: Introduction to the Bond Sudoku valuation framework

Bond Sudoku is an econometric framework that provides fair values for 10-year government bond yields in advanced economies. Inputs to the model include 1-year-ahead expectations on real GDP growth, CPI inflation and 3-month interest rates. A key feature of Sudoku is that the framework explicitly accounts for the interconnections within the global government bonds market. The current version of the model is estimated on a sample starting in 1990 and covers US, German, Japanese, UK, Canadian, Australian, Swiss and Swedish government bond markets. We regularly use the output of Sudoku as an important ingredient in our strategy work. For more details, please see our previous publications on this model: Global Viewpoint 08/04 from February 7, 2008, Australia Plays Sudoku, Global Viewpoint 07/24 from July 25, 2007, Sudoku Gets Bigger and Forward-Looking!, The Foreign Exchange Market 2006, Chapter 12, The Bond Yield Sudoku and Global Viewpoint 06/08 from February 8, 2006, The Bond Yield Sudoku.
%

USA 10-yr Bond Yield

Actual Fundamental

10 9 8 7 6 5 4 3 2 90 92 94 96 98 00 02 04 06 08
Source: Goldman Sachs Global ECS Research

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Establishing a long run Equilibrium Value

In the above fair value calculations, we use current bond yields (or those adjusted by our fair value model) and an assessment about current risk appetite. As discussed above, probably the most controversial input into this model is the ERP. In the central assumptions we plug in an ERP that relates to a band in relation to long run averages. If we think that uncertainty is high (as we do currently) we input an ERP in the highest quartile of historical patterns and vice versa when the market is trending and growth is robust. The advantage of this approach is that it gives an idea about what fair value is at the moment by using an ERP that is reasonable given the current economic environment. Arguably, however, this adds a further layer of subjectivity. We can think of two sensible alternatives that help pin down this issue, which each illuminate different issues. The first is to try to model more formally what an appropriate ERP "should" be given a particular economic environment. This is one of the things our follow up report: Part II will address. The second is to think about what the fair value of the market would be if economic conditions were to reach long run equilibrium. We consider an ERP of 3% and a real bond yield of 2% as reasonable benchmark case. Using those assumptions, Chart 4 shows how fair value has fluctuated over time. While we do not explicitly use the deviation from equilibrium fair value as a forecasting tool, a good measure of equilibrium fair value should have the property that market values tend to move towards the equilibrium value over time. Chart 5 shows the yearly return of the S&P 500 index plotted against the deviation from long run fair value at the beginning of the year. The R2 shows that 15% of the variation in yearly returns over time can be explained by the markets deviation from fair value at the beginning of the year. The slope coefficients shows that for each 1 percentage point increase in upside to equilibrium fair value at the beginning of the year, returns during the year increase by 0.3 percentage points.

3) Equilibrium value, assuming a long run normalised level of real bond yields and ERP

Comparison of approaches
The three approaches are compared in Table 5. On current assumptions, all markets are undervalued, with the Europe being the most attractive and Japan and Asia the closest to fair value. By applying an assessment of current fair value bond yields as defined by our Sudoku model, the broad conclusions remain the same though the undervaluation of European equities becomes significantly larger.
Chart 4: GS DDM, US equilibrium value % deviation form fair value assuming fixed ERP at 3% and real bond yield of 2%
60%

Chart 5: Returns are higher when the upside to fair value is large at the start of the year

50
40% 20% 0% -20% -40%

Overvalued

Return over the next year (%)

40 30 20 1 0 0 -1 0 -20 -30 -40 -50 -60 -40 -20 0

y = 0 .3 19 7 x + 9 .2 16 2 R 2 = 0 .14 5 7

Undervalued
-60% Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07

20

40

Ups ide t o lo ng run f a ir v a lue ( %)

Source: Datastream, Haver analytics, Goldman Sachs Global ECS Research. Issue No: 179

Source: Factset, Haver analytics, Goldman Sachs Global ECS Research

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Table 5: Fair value and upside/(downside)

Central Scenario Current Level 846 195 786 266 Fair Value Level 941 224 809 277 Fair Value Upside / (Downside) 11% 15% 3% 4% Using Sudoku Fair Value Bond model Fair Value Level 943 274 916 NA Fair Value Upside / (Downside) 12% 41% 16% NA Using equilibrium ERP* and 2% real interest rate Fair Value Level 1152 333 886 349 Fair Value Upside / (Downside) 36% 71% 13% 31%

US (S&P 500) Europe (Stoxx 600) Japan (TOPIX) Asia (MSCI APxJ)

Source: Goldman Sachs Global ECS Research

Assuming the ERP (which we believe is currently unusually high) reverts to a long run average of 3% in the developed markets and 4% in Asia and using a trend average real bond yield, all markets are substantially undervalued. The range of undervaluation is from 13% in Japan to 71% in Europe.

Sensitivities to assumptions
While the model helps to identify the potential upside or downside to fair value, it is very sensitive to changes in inputs and structure. But how much do changing assumptions matter and which variables are the most sensitive? In the section we examine these assumptions and sensitivities in more detail.

Near-term earnings expectations Phase I

How do you measure earnings? The first phase of the model is an explicit forecast period based on our own top down operating profit assumptions generated from our regional profit models (details can be obtained on request). We assume that earnings revert to the historical trend rate of growth by the end of 2012 (Phase II). Given how the model is set up, changes in near-term earnings expectations do not affect fair value to a very large extent, since we assume that earnings recover to trend by the end of the fourth year in the model. Table 7 shows the impact on fair value in Europe, as an example, of changes in the assumptions for earnings growth in fiscal years 1 and 2 (out to 2010). Our current assumptions for the DJ STOXX 600 are for operating profits to fall 16% this year and to rise by 8% in 2010. As with many other markets, these numbers may be heavily distorted by financials for this year. For example, our top down model assumes that financial earnings rise by 29% this year after a fall of 47% in 2008 (mainly as a result of lower writedowns). However, we do not have much confidence in these numbers given the uncertainty over banks writedowns currently. Excluding financials, we assume earnings fall 30% this year. If we assume that this is true for the market as a whole, and the recovery in 2009 is still 8% from that lower level, it implies that the market is close to

Table 6: Short-term earnings growth expectations

FY indicates fiscal year. For Europe, US and Asia, fiscal years end December 31. For Japan, fiscal years end March 31.

US Europe Japan Asia

Earnings growth assumptions FY3 and FY4 Trend FY1 FY2 CAGR ROE -5% 31% 3% 14% -16% 8% 3% 13% -37% -3% 8% 6% -15% 17% 5% 15%

Source: Goldman Sachs Global ECS Research

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Table 7: Sensitivity of fair value for European market to short-term earnings forecasts
shading represents current estimates

Nominal FY2 earnings growth

-41% -36% -31% -26% -21% -16% -11% -6% -1% 4% 9% -17% -12% 0% 1% 1% 3% 3% 4% 4% 6% 6% 7% 7% 9% 9% 11% 11% 12% 12% 14% 14% 16% 15% 17% -7% 2% 4% 5% 7% 9% 10% 12% 14% 16% 17% 19% -2% 4% 5% 7% 8% 10% 12% 14% 16% 17% 19% 21% 3% 5% 6% 8% 10% 12% 14% 15% 17% 19% 21% 23% 8% 6% 8% 10% 11% 13% 15% 17% 19% 21% 23% 25% 13% 8% 9% 11% 13% 15% 17% 19% 21% 23% 25% 27% 18% 9% 11% 13% 15% 17% 19% 21% 23% 25% 27% 29% 23% 11% 12% 14% 16% 18% 20% 22% 24% 26% 29% 31% 28% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 33% 33% 14% 15% 17% 19% 22% 24% 26% 28% 30% 32% 35%

Source: Goldman Sachs Global ECS Research

fair value (10% upside).

Return to trend growth Phase II

In our second phase, the growth rate in earnings that is used is the rate over two years that gets ROE back to a trend level. As explained earlier, we think it is important to have this catch-up phase as it reduces distortions resulting from large movements away from trend growth that may occur for a short period around booms or recessions. Our historical analysis suggests that in most cycles a return to trend over a longer period is realistic. We find that this is the average amount of time it has taken in the past three recoveries, although there is some variation around the mean. For example, in the profit-less recovery of the early 1990s, it took over four years for earnings to reach the trend line. It makes sense to fade the level of growth to trend but what is the right trend assumption? The appropriate assumptions for trend ROE is open to interpretation. Recent years have seen unusually high ROEs. Work that disaggregates ROE on a Dupont basis done by our Strategists, suggests that much of the rise has been attributable to rising margins as a result of globalization and technology
Table 8: Downside/upside to fair value based on various return on equity

Nominal FY1 earnings growth

Upside / (Downside) to Fair Value varying Return on Equity (trend) ROE US Europe Japan -33% -27% -12% 5.0% -28% -22% 6.0% -1% -23% -16% 7.0% 10% -17% -11% 21% 8.0% -12% -6% 32% 9.0% -7% -1% 44% 10.0% -2% 5% 55% 11.0% 3% 10% 67% 12.0% 79% 13.0% 9% 15% 20% 91% 14.0% 14% 19% 26% 103% 15.0% 24% 31% 115% 16.0% 29% 36% 127% 17.0% Assumption 13.5% 13.0% 6.4%

Asia -39% -35% -31% -26% -22% -17% -13% -9% -4% 0% 5% 9% 13% 14.9%

Source: Goldman Sachs Global ECS Research

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substitution and increased leverage, particularly in the financial sector. The current trend ROE assumptions that we have used in each region appear at the bottom of the table on Table 8. Obviously changing this assumption makes a difference to the current fair value. In the case of the US, for example, a return to previous peak ROE (around 17%) would imply about 30% upside to the market. Meanwhile, if we applied a 10% ROE, the market would be overvalued by 7%.

Trend growth Phase III and IV

More important to the model, given the duration of equities, is the long-term assumed growth rate in profits. In our terminal assumptions we ensure that any future growth is offset by a commensurate decline in the payout ratio, to ensure that the growth rate cannot be in excess of the cost of equity in perpetuity. Consequently, very long-term growth assumptions do not affect fair value. However, since we allow the payout ratio to stay at the average of the past 5 years over the third phase of the model years 5-20 the growth rate assumed over this period does have a big impact on fair value. Table 9 shows the sensitivity of the long run growth assuming other things remain unchanged. The long run assumptions that we use are broadly in line with long term trend real GDP growth assumptions. For example we use 2.5% in Europe and 3% in the US. Is it fair to assume that long-term profit growth is equal to long-term trend GDP? While many investors might currently question the sustainability of long-term growth rates as we enter a period of higher regulation and lower leverage, there are factors that suggest that our central assumptions underestimate likely longterm growth over a 20 year time horizon. In particular, we use growth rates that approximate to domestic trend GDP estimates. Arguably many markets, particularly the developed ones, should enjoy a growing share of the higher growth rates for the global economy given their increasing sales exposure to fast growing emerging markets. An increase in the long-term growth assumption of 0.5% from our central
Table 9: Upside/downside in fair value based on various long-term growth rates

Upside / (Downside) to Fair Value varying Real Long Term Growth LT Growth US Europe Japan -23% -12% -21% 0.0% -19% -7% -16% 0.5% -13% -2% -10% 1.0% -8% 3% -4% 1.5% -2% 9% 2.0% 3% 4% 10% 2.5% 15% 22% 18% 3.0% 11% 19% 29% 26% 3.5% 26% 37% 35% 4.0% 35% 45% 45% 4.5% 44% 53% 56% 5.0% 54% 63% 67% 5.5% 64% 73% 79% 6.0% Assumption 3.0% 2.5% 2.0%

Asia -34% -30% -26% -22% -17% -12% -7% -2% 4% 11% 17% 25% 33% 4.0%

Source: Goldman Sachs Global ECS Research

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assumption would raise the fair value upside in mature markets like the US and Europe by 7%-8%.

The payout ratio

How do you deal with the payout ratio as it varies over time? The DDM model requires an input for the payout ratio. We vary the assumed rate across the phases of the model. We start with the current dividend yield but make a modest adjustment to the current payout ratio for the explicit forecast years so that the historical ratio varies by a factor that relates to the strength of the forecast growth rate. The reason for this adjustment is that earnings tend to be more volatile than dividends, so in years when earnings growth accelerates, the payout ratio would be expected to fall moderately and vice versa in a year when earnings are weak or fall. The adjustment factor only really makes a difference if the growth rate in the explicit forecast years is significantly different from the past years growth rate. Currently, the payout ratio is highest in Japan (67%), then Europe (44%), US (39%) and Asia (35%). All four regions have seen the payout ratio increase over the last year as earnings growth has turned negative, although the US has had a slight dip downwards in recent months and companies have been relatively more aggressive in cutting dividends (See Chart 6). For Phase III, years 5-20, we assume that the payout ratio is the trailing 5-year average, as of today. In Phase IV, the terminal phase, we assume that in the long-run companies retain just enough to maintain long-term growth and pay out the rest as dividends. For the terminal stage, we assume that two constraints need to be met. In the long run, real earnings should grow in line with real GDP, in order for the corporate share of the economy to remain stable. The expected return on capital should equal the expected cost of capital as companies cannot be expected to generate outsize returns in perpetuity. By using a sustainable payout ratio, e.g. one that varies inversely with the long-term growth rate and ROE, we satisfy both conditions. Years 5-20, Phase III of the model, is the most sensitive to the payout ratio used. Arguably if investors expect lower growth opportunities in years ahead they might expect to see a higher payout ratio over this period. Changing this
Chart 6: Payout ratios
65% 60% 55% 50% 45% 40% 35% 30% 25% 20% Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Europe Japan US Asia ex Japan

Table 10: Payout ratios Current, 5, year average and sustainable rate
Payout Ratio 5y sustainable average rate 32.1% 47.4% 40.9% 62.0% 33.8% 62.5% 34.6% 42.0%

US Europe Japan Asia ex-Japan

Current 39.3% 44.2% 66.6% 35.3%

Source: Datastream, Goldman Sachs Macro Strategy Research

Source: Goldman Sachs Global ECS Research

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Table 11: Upside/downside in fair value based on various interim payout ratios

Upside / (Downside) to Fair Value varying Interim Payout Ratio Payout Ratio US Europe Japan 5% 1% -5% 25.0% 7% 3% -3% 27.5% 6% 0% 30.0% 10% 8% 32.5% 12% 2% 14% 10% 35.0% 4% 16% 12% 6% 37.5% 18% 8% 40.0% 14% 20% 10% 42.5% 17% 22% 19% 12% 45.0% 24% 21% 14% 47.5% 26% 23% 16% 50.0% 28% 25% 18% 52.5% 30% 28% 21% 55.0% Assumption 32.1% 40.9% 34.0%

Asia -4% -2% 0% 2% 5% 7% 9% 11% 13% 15% 17% 20% 22% 34.6%

Source: Goldman Sachs Global ECS Research

does have some impact, as shown in Table 11. For each region the current assumption we use is highlighted at the bottom of the table. Note that Europe has traditionally had a much higher payout ratio than the other markets. In the case of Europe, for example, a fall in the ratio to 35% similar to the other markets would imply the market is currently only 10% undervalued. Put another way, if the other markets were to increase their payout ratio over years 5-20 to similar levels as Europe, it would significantly increase the current degree of undervaluation in other markets. Having different payout ratios over this period from market to market does, however, make sense given the differences in maturity of industries, end demand markets and cyclicatity of the various regions.

Table 12: Upside/downside in fair value based on various risk free rates Upside / (Downside) to Fair Value varying Nominal risk-free rate

Chart 7: Bond Yields around the world

12 10 US Japan Europe

Risk-free Rate 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% Assumption

US -23% -19% -13% -8% -2% 4% 11% 19% 26% 35% 44% 54% 64% 2.9%

Europe 233% 172% 128% 94% 67% 46% 29% 15% 3% -7% -15% -22% -29% 3.5%

Japan 57% 33% 13% -2% -14% -24% -32% -39% -45% -50% -54% -58% -61% 1.3%

Asia 539% 377% 272% 199% 146% 106% 75% 51% 31% 15% 2% -9% -19% 4.9%

8 6 4 2 0 Dec-88

Dec-92

Dec-96

Dec-00

Dec-04

Dec-08

Source: Datastream

Source: Goldman Sachs Global ECS Research

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The 10-year bond rate

Table 2 shows our assumptions for each of the perpetuity inputs. We use the current 10-year bond yield for the risk-free rate (for Asia Pacific, we equity cap-weight the bond yields and inflation rates for the different countries) and the 5-year trailing inflation rate as a proxy for long-run inflation expectations. Assumptions about the risk free rate have a big impact on fair value as do our inflation assumptions given that we look at the bond yield in real terms. We discussed at the start of this report, for example, that applying our bond strategists assumptions about fair value for bond markets makes a reasonable difference relative to applying the current market levels, particularly for the US and Europe. All things being equal, a lower bond rate results in a higher fair value for the index. What Inflation assumptions do you use? There is no perfect way to measure inflation expectations. We have looked at survey data, but this only has a long history in the US. There is of course an observed market implied inflation rate form the Index linked or TIPS market, in addition to survey based measures. Unfortunately these measures can vary quite significantly over time and are not available in all markets. The current implied rates of inflation in the indexed linked markets are also potentially distorted by liquidity factors. As a proxy, we have used the 5-year average core inflation measure. Table 13 shows how much the chosen inflation rate impacts the current fair value in the case of the United States as an illustration.
Table 13: The impact of different inflation measures on fair value

Inflation measures 5 year average core inflation Implied by index linked bond market University of Michigan Surveys of Consumers
Source: Goldman Sachs Global ECS Research

Inflation Expectations 0.0% 0.3 3.0

Fair Value 941 632 1154

The Equity Risk Premium

The final input into the DDM is the equity risk premium, a topic that could be the subject of a report on its own. Although we have a model for the ERP we
Table 14: Upside/downside in fair value based on various ERPs

Upside / (Downside) to Fair Value varying Equity Risk Premium ERP US Europe Japan 230% 172% 223% 2.0% 162% 128% 151% 2.5% 113% 94% 102% 3.0% 77% 67% 66% 3.5% 50% 46% 39% 4.0% 28% 29% 19% 4.5% 5.0% 11% 15% 3% -3% 3% -10% 5.5% -14% -6% -21% 6.0% -23% -15% -29% 6.5% -31% -22% -36% 7.0% -38% -28% -43% 7.5% -44% -33% -48% 8.0% Assumption 5.0% 5.0% 5.0%

Asia 287% 210% 154% 112% 80% 55% 34% 18% 4% -7% -17% -25% -32% 6.0%

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cannot use the current inputs from this for the purposes of this model as the results would be circular. Instead we take a range of ERP from this model historically and then assume a number relative to the range that we think is appropriate. Clearly this is controversial and is more art than science. But in choosing a number we are guided by the results of our proprietary Risk Aversion Index, among other things. The broad assumption we use currently is that the ERP is towards the higher band of its long run average given heightened uncertainty about the economic cycle, inflation and efficacy of unconventional central bank and government intervention. We currently use the same equity risk premium for all the mature regions of the world at 5% and use 6% for Asia. These levels are significantly higher than long run averages but are justified by the extreme economic conditions. Table 14 shows how even very small changes in the equity risk premium affect the fair value of the different regions, leaving all other assumptions untouched. Wouldnt it be better to fix the ERP over time to get a sense of equilibrium value? This is precisely the assumption that we make in assessing the 'equilibrium' level for the market, using a 3% constant ERP, which is roughly the historical average implied ERP since 1983 for the mature markets. As we have shown, by doing so, the fair value estimates currently would be much higher. Viewed in isolation, a fall back to 3% would justify rises in the equity markets of 100%-150%. There are two problems with this approach. First, there may be good arguments why the ERP could stay higher over the longer term than it has averaged over recent years (related to higher regulation, taxation and so on) and so it is useful to be able to think about market valuation sensitivities to those kinds of shifts as in Table 14. Even in the shorter-term, there are also good reasons why the ERP is justifiably higher in bad economic times than in good ones. This is why we think it is more appropriate to use a higher ERP to assess the current 'fair value' than the 3% average. The linkages between the ERP and the economic backdrop are something that we will explore in more detail in our next paper. Second, in reality, the ERP also tends not to adjust in isolation. Typically it will fall at a time when expectations for a recovery emerge. Under these circumstances, the bond yield may also rise. Table 15 shows what the fair value changes would be under different ERP and bond yield assumptions for Europe currently. A fall in the ERP back to, say 3%, coupled with a rise in the bond yield to, say 4.4%, would imply a 50% upside to the market! The fact that yields and the ERP are not independent is one reason too why in our
Table 15: Sensitivity of fair value for European market to the 10yr bond yield and ERP Shading represents current estimates Equity Risk Premium
2.0% 2.3% 2.6% 2.9% 3.2% 3.5% 3.8% 4.1% 4.4% 4.7% 5.0% 2.5% 318% 263% 219% 183% 153% 128% 106% 88% 72% 59% 47% 3.0% 232% 194% 162% 136% 113% 94% 77% 63% 50% 39% 29% 3.5% 172% 144% 120% 100% 82% 67% 54% 43% 32% 23% 15% 4.0% 128% 107% 88% 72% 58% 46% 36% 26% 18% 10% 3% 4.5% 94% 78% 63% 50% 39% 29% 20% 13% 6% -1% -7% 5.0% 68% 55% 43% 33% 23% 15% 8% 1% -5% -10% -15% 5.5% 47% 36% 27% 18% 10% 3% -3% -8% -13% -18% -22% 6.0% 30% 21% 13% 6% -1% -6% -12% -16% -21% -25% -28% 6.5% 16% 8% 2% -4% -10% -15% -19% -23% -27% -31% -34% 7.0% 4% -2% -8% -13% -18% -22% -26% -29% -33% -36% -38% 7.5% -6% -11% -16% -20% -24% -28% -31% -35% -37% -40% -43%

Current fair values are highly sensitive to the ERP and bond yields

Source: Goldman Sachs Global ECS Research Issue No: 179

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Table 16: Global stock market recoveries from recession-based bear markets
Returns BEFORE the Trough (%) Returns AFTER the Trough (%) Earnings (%) Length in Total Peak dates Trough dates Months Decline S&P 29-Nov-68 26-May-70 18 -36% 05-Jan-73 03-Oct-74 21 -48% 28-Nov-80 12-Aug-82 20 -27% 16-Jul-90 17-Oct-90 3 -19% 24-Mar-00 09-Oct-02 31 -49% FT All Share 31-Jan-69 27-May-70 16 -37% 01-May-72 13-Dec-74 31 -73% 04-May-79 15-Nov-79 6 -23% 16-Jul-87 24-Sep-90 38 -22% 04-Sep-00 10-Mar-03 30 -49% DAX 17-Nov-69 05-Nov-71 24 -36% 23-Mar-73 06-Nov-74 19 -36% 19-Oct-78 17-Aug-82 46 -22% 30-Mar-90 06-Oct-92 30 -28% 07-Mar-00 12-Mar-03 36 -73% Topix 18-Dec-89 14-Aug-92 32 -61% 26-Jun-96 15-Oct-98 28 -43% 07-Feb-00 11-Mar-03 37 -56% AVERAGE STD DEV 26 11.1 -41% 0.2 12m -34 -43 -23 -12 -27 -23 -56 0 -20 -35 -11 -18 -7 -11 -58 -37 -27 -32 -26 16.0 6m -26 -34 -10 -13 -31 -19 -47 -18 -15 -18 -14 -13 0 -18 -36 -28 -21 -16 -21 10.9 3m -22 -26 -14 -19 -18 -19 -29 -12 -18 -12 -19 -9 -2 -20 -29 -20 -23 -10 -18 7.2 3m 17 10 38 5 19 14 106 21 8 22 20 19 9 8 43 11 8 13 22 23.3 6m 21 33 42 28 13 15 133 15 24 27 30 39 19 17 65 15 36 33 34 27.9 12m 44 38 58 31 34 44 146 39 30 37 28 43 52 40 77 50 54 46 50 26.8 12m after trough -2 -6 -15 -9 32 6 -25 23 -10 19 28 -4 -29 23 -25 -25 10 -1 20.2 P/E DY

at trough at trough 13 7 7 14 30 13 3 7 10 14 11 11 12 9 31 37 31 15 10.2 4.3 5.9 6.7 4.1 2.0 5.3 12.1 6.7 5.8 4.5 5.2 4.4 3.1 3.8 1.1 1.1 1.2 4.5 2.7

Source: Datastream, Goldman Sachs Global ECS Research

'equilbrium value' measures we fix both, using long-run average real interest rates and ERP. This shows how the market would be valued under a 'normal' discount rate and helps to illustrate how much of the market's level can be explained through a discount rate that is different from the 'average'. We think the common practice of using current bond yields but a fixed ERP is a much harder assumption to motivate. While these numbers may look extreme, they are not so unrealistic if we look at what has actually happened in terms of recoveries from major bear markets in the past. Table 16 shows the recovery profile from some of the deepest equity bear markets that were also associated with recessions. Two interesting observations can be made: The pace of recovery over the first 6-12 months from the final low is very high in every case. The lowest return was around 30%. The strength of this recovery is not dependent on the pace of earnings growth that follows the trough. As the third from final column shows, there is a much greater variation in corporate earnings growth following the trough in the market, than there is variation in returns. In effect, this suggests that much of the initial return in the market is driven by a fall in the equity risk premium. These results are, of course, also very close to the equilibrium fair value level that we generate by fixing the ERP at a long run average of 3% and the real bond yield at 2%. Clearly there are many issues with using a DDM approach to estimate fair values; many of the assumptions are debatable and the level of the ERP in particular makes a big difference to the current levels. Nonetheless, our model does suggest there is strong upside to the market, particularly when we apply our own estimates of bond market fair value and assume even modest normalization in the ERP. The ERP is the subject of Part II of this valuation report. Peter Oppenheimer, Jessica Binder and Anders Nielsen
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Preview of the forecasting returns approach to valuation Forecasting the ERP

Markets can stay above or below fair value for a long time. It is therefore of interest to investors to know not only what the eventual fair value is but also how quickly the market is likely to move towards it. We will devote a separate report to this aspect of valuation and provide a preview here. To answer this question we derive a time series of the implied ERP by solving for the value of the ERP that at any given point in time makes the fair value V equal the observed market price, where: We then analyze which economic variables drive the historical variation in the implied ERP, and use that historical relationship in combination with Goldman Sachs economic forecasts to derive a forecast for the implied ERP. Finally, we use this forecast, together with our forecasts for earnings and interest rates in the valuation formula above, to calculate the expected price of the market 1 year into the future.

V =

20 PO1 * E1 POIM * E1 * (1 + RGDP)t 1 (1 + INFL)t 1 + (1 + ERP + r10 ) t =2 (1 + ERP + r10 )t

1 E20 * (1 + RGDP) 20 (1 + ERP + r10 ) ( ERP + r10 INFL)

Source: Goldman Sachs Global ECS Research

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Reg AC and Disclosures

We, Peter Oppenheimer, Jessica Binder, CFA, Anders Nielsen, Gerald Moser and Sharon Bell, CFA, hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report.

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GOLDMAN SACHS GLOBAL RESEARCH CENTRES

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