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Cost of Capital Resources Center Methodology

SBBI Valuation Essentials Module

Introduction Data Availability by Version Additional Data Citation Wealth Indices of Investments in the U.S. Capital Markets Description of the Basic Series Summary Statistics of Annual Returns Definition of Terms Description of the Series Equity Risk Premia Definition of Terms Arithmetic versus Geometric (compound) Returns Historical versus Supply Side Models Reading the Tables Size Premia Definition of Terms Size Premia Derivation Using Size Premia Size-Decile Portfolios Largest and Smallest Companies by Size Group Industry Premia Estimates Industry Risk Premia (IRP) Data Availability by Version Industry Risk Premia Derivation Reason for Industry Premia Adjustments to Buildup Method Using Industry Risk Premia Industry Premia Company List List of Companies Used to Calculate Each Industry Premium (IRP) Long-Term and Intermediate-Term U.S. Government Bond Yields Definition of Terms Key Variables in Estimating the Cost of Capital Yields Equity Risk Premia Size Premia by Size Groupings Size Premia by Deciles Appendix Buildup Method Example 1 CAPM Example 1

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Introduction

Morningstar is pleased to present the SBBI Valuation Essentials Module as part of our Cost of Capital Resources Center website. The SBBI Valuation Essentials Module contains the essential valuation data and analysis from each of Ibbotson Associates® SBBI Valuation Edition Yearbooks (1999-Present). ``SBBI Valuation Essentials'' features up to thirteen separate tables*, one for each of the following: Group 1 · Long-Horizon Equity Risk Premia · Intermediate-Horizon Equity Risk Premia · Short-Horizon Equity Risk Premia · Mid-Cap Size Premia · Low-Cap Size Premia · Micro-Cap Size Premia Group 2 · Wealth Indices of Investments in the U.S. Capital Markets · Summary Statistics of Annual Returns · Size-Decile Portfolios of the NYSE/AMEX/NASDAQ · Industry Premia Estimates · Industry Premia Company List · Long-Term and Intermediate-Term U.S. Government Bond Yields · Key Variables in Estimating the Cost of Capital *All of the tables are data through year-end of the year preceding the version year. Example: the ``2011 SBBI Valuation Essentials'' is data through December, 2010. Data Availability by Version The following table is a summary of what is featured in each version of ``SBBI Valuation Essentials''. Note that we have included the 10a, 10w, 10x, 10b, 10y, 10z split and the supply side equity risk premium estimate in the key variables group. Both the 10th decile splits and the supply side ERP are published in the widely used table ``Key Variables in Estimating the Cost of Capital'' (known to many SBBI Valuation Edition Yearbook users as the ``back page''), so we have included them in the grid for your convenience. In keeping with tradition (and convenience), the table ``Key Variables in Estimating the Cost of Capital'' is the back page of all versions of ``SBBI Valuation Essential'' as well. X Available ---- Not Available Wealth Indices of Investments in the U.S. Capital Markets (Graph) Summary Statistics of Annual Returns Long-Horizon Equity Risk Premia (all historical time periods) Intermediate-Horizon Equity Risk Premia (all historical time periods) Short-Horizon Equity Risk Premia (all historical time periods) Mid-Cap Size Premia (all historical time periods) Low-Cap Size Premia (all historical time periods) Micro-Cap Size Premia (all historical time periods) Size-Decile Portfolios Industry Premia Estimates Industry Premia Company List Long-Term and Intermediate-Term U.S. Government Bond Yields Key Variables in Estimating the Cost of Capital 10a, 10b Split 10w, 10x, 10y, 10z Split Supply Side Equity Risk Premia Estimate 1999 X X X X X X X X X X X 2000 X X X X X X X X X X X X 2001 X X X X X X X X X X X X X 2002 X X X X X X X X X X X X X 2003 X X X X X X X X X X X X X X SSBI Valuation Essentials version 2004 2005 2006 2007 X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X 2008 X X X X X X X X X X X X X X X 2009 X X X X X X X X X X X X X X X 2010 X X X X X X X X X X X X X X X X 2011 X X X X X X X X X X X X X X X X

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Additional Data Wherever possible, additional data has been included. For instance, the graph ``Wealth Indices of Investments in the U.S. Capital Markets'' did not appear in the 1999 SBBI Valuation Edition Yearbook, but did appear in Ibbotson's 1999 SBBI Classic Edition Yearbook, so we have opted to include it in the 1999 version of ``SBBI Valuation Essentials'' for completeness. The information found in the table ``Breakdown by Decile'' was not presented in ``Key Variables in Estimating the Cost of Capital'' in the 1999 through 2002 SBBI Valuation Edition Yearbooks, but this information is presented in the 1999 through 2002 versions of ``SBBI Valuation Essentials'' (the breakpoints and size premia are wholly taken from other tables published within each of the respective yearbooks). Additionally, intermediate- and short-term equity risk premia have not been published in the SBBI Valuation Edition Yearbook's ``Key Variables in Estimating the Cost of Capital'' since 2002, but, for completeness, we have included these values on all ``back pages'' of SBBI Valuation Essentials''--and once again, these values were wholly taken from other tables published within each of the respective yearbooks. Citation For citation purposes, each table and graph in ``SBBI Valuation Essentials'' is sourced at the top with the yearbook edition, original table name, and other useful information. For example, in ``2011 Valuation Essentials'', the ``back page'' is labeled as shown below: Key Variables in Estimating the Cost of Capital 2011 SBBI Valuation Edition Yearbook: Appendix C, Table C-1, page 196 As of December 31, 2010 Users can cite either the original SBBI Yearbook or cite ``SBBI Valuation Essentials''. The preferred citation is as follows: ``Source: <insert publication name, table number, page number, etc.>© <Insert applicable date> Morningstar. All rights reserved. Used with permission. This information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information'' We have strived to make each version of ``SBBI Valuation Essentials'' a true representation of the most critical data and analysis in each edition of Ibbotson's SBBI Valuation Edition Yearbooks. Your comments are important to us, and are the source of many of our ideas for keeping Morningstar products the best in the business. We welcome your questions, comments, and ideas. For additional information about Morningstar publications and products, call Product Sales at (888) 298-3647, or visit global.Morningstar.com/DataPublications.

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Methodology: SSBI Valuation Essentials

Wealth Indices of Investments in the U.S. Capital Markets

Wealth Indices of Investments in the U.S. Capital Markets: graphical depiction of $1.00 invested in large company stocks, small company stocks, long-term government bonds, Treasury bills, and a hypothetical asset returning the inflation rate over the period from the end of 1925 to the end of the year preceding the version year.

Example: In ``2011 SBBI Valuation Essentials'', the graph Wealth Indices of Investments in the U.S. Capital Markets is over the period year-end 1925 to year-end 2010. Descriptions of the Basic Series Large Company Stocks---- the market for U.S. large company stocks is represented here by Standard and Poor's 500 Stock Composite Index® (S&P 500). The total return includes reinvestment of dividends. Small Company Stocks---- a portfolio of stocks represented by the fifth capitalization quintile of stocks on the NYSE for 1926--1981. For January 1982 to March 2001, the series is represented by the DFA U.S. 9--10 Small Company Portfolio and the DFA U.S. Micro Cap Portfolio thereafter. Long-Term Government Bonds---- a one-bond portfolio with a maturity near 20 years. Treasury Bills---- a one-bill portfolio containing, at the beginning of each month, the bill having the shortest maturity not less than one month. Inflation---- the rate of change in consumer prices. The Consumer Price Index for All Urban Consumers (CPI-U), not seasonally adjusted, is used to measure inflation. Prior to January 1978, the CPI (as compared with CPI-U) was used. Both inflation measures are constructed by the U.S. Department of Labor, Bureau of Labor Statistics, Washington D.C.

Summary Statistics of Annual Returns

Summary Statistics of Annual Returns: summary statistics of the annual total returns on each asset class over the entire period of 1926 to the end of the year preceding the version year.

Example: In ``1999 SBBI Valuation Essentials'', the table ``Summary Statistics of Annual Returns: Basic Series'' is over the period 1926 to year-end 1998. Definition of Terms Total Return---- a measure of performance of an asset class over a designated time period. It is comprised of income return, reinvestment of income return and capital appreciation return components. Income---- the component of total return which results from a periodic cash flow, such as dividends. Capital Appreciation---- the component of total return which results from the price change of an asset class over a given period. Description of the Series Large Company Stocks---- the market for U.S. large company stocks is represented here by Standard and Poor's 500 Stock Composite Index® (S&P 500). The total return includes reinvestment of dividends. Ibbotson Small Company Stocks---- a portfolio of stocks represented by the fifth capitalization quintile of stocks on the NYSE for 1926-1981. For January 1982 to March 2001, the series is represented by the DFA U.S. 9--10 Small Company Portfolio and the DFA U.S. Micro Cap Portfolio thereafter. Mid-Cap Stocks*---- the portfolio of stocks comprised of the 3--5th deciles of the New York Stock Exchange, including similar-size AMEX and NASDAQ companies.

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Low-Cap Stocks*---- the portfolio of stocks comprised of the 6--8th deciles of the New York Stock Exchange, including similar-sized AMEX and NASDAQ companies. Micro-Cap Stocks*---- the portfolio of stocks comprised of the 9--10th deciles of the New York Stock Exchange, including similar-sized AMEX and NASDAQ companies. Long-Term Corporate Bonds---- Citigroup long-term, high-grade corporate bond total return index. Long-Term Government Bonds---- a one-bond portfolio with a maturity near 20 years. Intermediate-Term Government Bonds---- A one-bond portfolio with a maturity near 5 years. Treasury Bills---- a one-bill portfolio containing, at the beginning of each month, the bill having the shortest maturity not less than one month. Inflation---- the rate of change in consumer prices. The Consumer Price Index for All Urban Consumers (CPI-U), not seasonally adjusted, is used to measure inflation. Prior to January 1978, the CPI (as compared with CPI-U) was used. Both inflation measures are constructed by the U.S. Department of Labor, Bureau of Labor Statistics, Washington D.C. *NOTE: In the 1999 and 2000 SBBI Valuation Edition Yearbooks the decile portfolios were composed of NYSE stocks only. Since 2001, the decile portfolios have been composed of deciles of the New York Stock Exchange, plus similar-sized AMEX and NASDAQ companies. Source of underlying returns and breakpoints for NYSE and NYSE/AMEX/NASDAQ deciles: ©2011 CRSP®, Center for Research in Security Prices. Graduate School of Business, The University of Chicago used with permission. All rights reserved. www.crsp.chicagogsb.edu.

Equity Risk Premia

Definition of Terms Expected equity risk premium---- can be defined as the additional return an investor expects to receive to compensate for the additional risk associated with investing in equities as opposed to investing in riskless assets. It is an essential component in several cost of equity estimation models, including the buildup method, the capital asset pricing model (CAPM), and the Fama-French three factor model. It is important to note that the expected equity risk premium, as it is used in discount rates and cost of capital analysis, is a forward-looking concept. That is, the equity risk premium that is used in the discount rate should be reflective of what investors think the risk premium will be going forward. The equity risk premia shown in the table ``Key Variables in Estimating the Cost of Capital'' (found on the last page of each ``SBBI Valuation Essentials'') are based on the time period from 1926 through year-end of the year preceding the version year. The original data source for the time series comprising the equity risk premium is the Center for Research in Security Prices (CRSP) at the University of Chicago. CRSP chose to begin their analysis of market returns with 1926 for two main reasons. CRSP determined that the time period around 1926 was approximately when quality financial data became available. They also made a conscious effort to include the period of extreme market volatility from the late twenties and early thirties; 1926 was chosen because it includes one full business cycle of data before the market crash of 1929. These are the two most basic reasons why our equity risk premium calculation window starts in 1926. Market Benchmark---- the total return of our large company stock index (currently represented by the S&P 500) was used as the market benchmark for the equity risk premia presented in all versions of ``SBBI Valuation Essentials''. Riskless asset---- the return on a riskless investment; it is the rate of return an investor can obtain without taking market risk. · Income Return---- it is important to note that the income return on the appropriate-horizon Treasury security, rather than the total return, is used in the calculation of equity risk premia. Total return is comprised of three return components: income return, capital appreciation return, and reinvestment return. Income return is defined as the portion of the total return that results from a periodic cash flow or, in this case, the bond coupon payment. Capital appreciation return results from the price change of a bond over a specific period. Bond prices generally change in reaction to unexpected fluctuations in yields. Reinvestment return is the return on a given month's investment income when reinvested into the same asset class in the subsequent months of the year. Income return is thus used in the estimation of the equity risk premium because it represents the truly riskless portion of the return.

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Time Horizon---- although the equity risk premia of several horizons are available, the long-horizon equity risk premium is preferable for use in most business-valuation settings, even if an investor has a shorter time horizon (remember that the cost of capital is a function of the investment, not the investor). Companies are entities that generally have no defined life span; when determining a company's value, it is important to use a long-term discount rate because the life of the company is assumed to be infinite. For this reason, it is appropriate in most cases to use the long-horizon equity risk premium for business valuation. For completeness, however, we have included long-, intermediate-, and short-horizon equity risk premia in ``SBBI Valuation Essentials'' for all historical time periods, calculated as follows: · Long-, Intermediate-, and Short-Horizon ---- long-, intermediate-, and short-horizon equity risk premia are calculated using the income return from a 20-year Treasury bond, a 5-year Treasury bond, and a 30-day Treasury bill, respectively.

Arithmetic versus Geometric (compound) Returns In general, arithmetic estimates are typically used in mean-variance analysis (or asset allocation) and business valuation practices, while geometric estimates are typically used to derive the median or the average accumulated wealth over period of time in wealth forecasting or simulation. The equity risk premium data presented in ``SBBI Valuation Essentials'' are arithmetic average risk premia as opposed to geometric average risk premia. The arithmetic average equity risk premium can be demonstrated to be most appropriate when discounting future cash flows. For use as the expected equity risk premium in either the CAPM or the Buildup Method approach, the arithmetic mean or the simple difference of the arithmetic means of stock market returns and riskless rates is the relevant number. This is because both the CAPM and the Buildup Method approach are additive models, in which the cost of capital is the sum of its parts. The geometric average is more appropriate for reporting past performance, since it represents the compound average return. Historical versus Supply-Side Models Historical equity risk premia presented in ``SBBI Valuation Essentials'' are defined as follows: · · ·

Long-horizon equity risk premia: large company stock total returns minus long-term government bond income returns. Intermediate-horizon equity risk premia: large company stock total returns minus intermediate-term government bond income

returns.

Short-horizon equity risk premia: large company stock total returns minus U.S. Treasury bill total returns.

These equity risk premia are based upon the historical differences in the returns of stocks and bonds. In updating Fisher and Lorie (1968), the Ibbotson and Sinquefield (1976a,b) studies provided aggregate market forecasts based upon historical returns from much of the twentieth century. Stemming from this work, Ibbotson Associates has been publishing historical equity risk premia in the SBBI Classic Edition Yearbook and the SBBI Valuation Edition Yearbook since 1976 and 1999, respectively. For example, in the 2007 SBBI Valuation Yearbook, the historical long-horizon expected arithmetic equity risk premium from 1926 through 2006 was calculated as the difference between the average annual U.S. large company stock total return over the 1926--2006 period and the average annual U.S. long-term government bond income return over the 1926--2006 period. In 2004, Ibbotson began publishing a long-horizon equity risk premium estimate based on a supply-side model in the SBBI Valuation Edition Yearbook's ``Key Variables in Estimating the Cost of Capital'' table. The supply-side equity risk estimate is defined as follows: ·

Long-horizon expected equity risk premium (supply side): historical equity risk premium minus price-to-earnings ratio

calculated using three-year average earnings.

Supply-side models use fundamental information such as earnings, dividends, or overall economic productivity to estimate expected equity risk premia. Diermeier, Ibbotson, and Siegel (1984) proposed a supply side approach to link the return of aggregate financial assets to the overall growth of economic productivity. This early paper provides the foundation for the supply models later developed by Ibbotson and Chen (2003), where a model was developed to estimate a forward-looking long-term equity risk premium using a combination of the historical and the supply side approaches. In Ibbotson and Chen's 2003 study, the historical equity return was broken into four components, with only three historically being supplied by companies: inflation, income return, and the growth in real earnings per share. The fourth component, growth in the P/E ratio, is a reflection of investors' changing predictions of future earnings growth and their willingness to pay for these earnings. This

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model assumes that the growth in P/E ratio that is embedded in historical returns is not sustainable, so this component is subtracted from the forecast. In the most recent update (1926--2010) of both historical and supply-side equity risk premia estimates, the long-horizon equity risk premium estimated using the supply side approach is only slightly lower than the pure historical return estimate. This confirms our belief that these two models are not in conflict, and we expect the results of these two methods to converge over time. We believe both methods are valid when used to estimate future equity risk premia. This updated result also confirms that the historical equity risk premium estimate is a very solid estimate, and should continue to serve as a starting point for applying the equity risk premium in portfolio optimization and business valuation. NOTE: It is important to understand that all equity risk premia estimates in ``SBBI Valuation Essentials'', with the exception of the single long-horizon supply-side estimate that is included in the table ``Key Variables in Estimating the Cost of Capital'', are calculated using the historical model. Also note that the equity risk premia used in the examples in this document's Appendix are calculated using the historical model. Reading the Tables Long-, Intermediate-, and Short-Horizon Equity Risk Premia are presented in two ways: 1) Most recent data---- In the table ``Key Variables in Estimating the Cost of Capital'', equity risk premia are calculated over the time period 1926 through year-end of the year preceding the version year (the ``data through'' date).

Example: equity risk premia presented in the table ``Key Variables in Estimating the Cost of Capital'' in ``2011 SBBI Valuation Essentials'' are calculated over the time period 1926 through year-end 2010. Example: equity risk premia presented in the table ``Key Variables in Estimating the Cost of Capital'' in ``2002 SBBI Valuation Essentials'' are calculated over the time period 1926 through year-end 2001. NOTE: each version's ``Key Variables in Estimating the Cost of Capital'' table is found on the last page. 2) Over all historical time periods---- these large wedge-shaped tables spanning 6--8 pages each enable users to customize their analysis by selecting any start and any end date.

The following example utilizes information from ``2007 SBBI Valuation Essentials''; table ``Long-Horizon Equity Risk Premia (in percent)''. *Example: to locate the long-horizon equity risk premium calculated over the time period 1967--2006: · · · Step 1---- locate the ``Start Date'' (in this case, 1967) along the horizontal axis of the appropriate table Step 2---- locate the ``End Date'' (in this case, 2006) along the vertical axis of the same table. Step 3---- the intersection of the ``Start Date'' column found in Step 1 and the desired ``End Date'' row found in Step 2 is the long-horizon equity risk premium calculated over the time period 1967--2006. -

Size Premia

One of the important characteristics not necessarily captured by the Capital Asset Pricing Model is what is known as the size effect. The need for this premium when using the CAPM arises because, even after adjusting for the systematic (beta) risk of small stocks, they outperform large stocks. The betas for small companies tend to be greater than those for large companies; however, these higher betas do not account for all of the risks faced by those who invest in small companies. Definition of Terms Long-Term Returns in Excess of Systematic Risk---- the greater risk of small stocks does not, in the context of the capital asset pricing model (CAPM), fully account for their higher returns over the long term. In the CAPM only systematic, or beta risk, is rewarded; small company stocks have had returns in excess of those implied by their betas.

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Size Premium---- the return on small company stocks in excess of that predicted by the CAPM. It is the additional return that cannot be explained by the betas of small companies. Note that the size premia in all ``SBBI Valuation Essentials'' are beta-adjusted size premia. In other words, the portion of the excess return on small stocks that can be explained by their higher betas is not included in the size premia. A non-beta-adjusted small stock premium can be calculated by subtracting the arithmetic mean of the large company stock return from the arithmetic mean of the small company stock return. The problem with using a non-beta adjusted small stock premium is that in doing so one assumes that the company being valued has the same systematic risk (or beta) as the portfolio of small stocks used in the calculation of the size premium. This ignores much of the information that we have regarding market returns---- primarily, that different industries tend to have different levels of systematic risk. Since the beta-adjusted size premium isolates the excess return due to size, it can be applied to a company without making any assumptions regarding the company's systematic risk. For example, utilities tend to be less risky than, say, oil exploration companies. If we have a utility company and an oil exploration company of equal size, we can apply the same beta-adjusted size premium to each, regardless of the companies' differing systematic risk. In the context of CAPM, the systematic risk is measured by beta, and using a non-beta adjusted size premium may constitute a double counting of this risk. In the context of the Buildup Method, which contains no beta measure, we can re-insert a measure of systematic risk by including an industry risk premium in the model (see page 13). NOTE: All size premia presented in ``SBBI Valuation Essentials'' are beta-adjusted size premia (both in the table ``Key Variables in Estimating the Cost of Capital'', and in the large wedge-shaped tables ``over all time periods''). Beta-adjusted size premia, and not nonbeta-adjusted size premia, are appropriate for use within the context of CAPM and the Buildup Method. Size Premia Derivation According to the CAPM, the expected return on a security should consist of the riskless rate plus an additional return to compensate for the systematic risk of the security. The return in excess of the riskless rate is estimated in the context of the CAPM by multiplying the equity risk premium by beta. The equity risk premium is the return that compensates investors for taking on risk equal to the risk of the market as a whole (systematic risk). Beta measures the extent to which a security or portfolio is exposed to systematic risk. Beta indicates the degree to which a security's (or portfolio's) return moves with that of the overall market. A company or portfolio with a beta of 1.0 has the same systematic risk as the overall stock market and, therefore, will provide expected returns to investors equal to those of the market. The return on a company or portfolio with a beta of 2.0 will, on average, rise approximately twice as much as the overall market during periods of rising stock prices. Stocks or portfolios with betas less than 1.0 have risk levels and, consequently, expected returns that are lower than that of the overall market. Recall that the CAPM is expressed as follows:

k s = rf + ( s × ERP)

where:

ks rf

= the cost of equity for company s;

= the expected return of the riskless asset; = the beta of the stock of company s; and = the expected equity risk premium, or the amount by which investors expect the future return on equities to exceed that on the riskless asset

s

ERP

Rearranging this equation:

k s - rf = ( s × ERP)

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Thus, beta times the equity risk premium represents the estimated return in excess of the riskless rate for company s. In the ``XXXX SBBI Valuation Essentials'', Mid-, Low-, and Micro-Cap stocks' size premia are as follows (column E): A From 1926 to XXXX Decile Mid-Cap, 3-5 Low-Cap, 6-8 Micro-Cap, 9-10 Beta 1.xx 1.xx 1.xx B Arithmetic Mean Return 14.xx% 15.xx% 18.xx% C Actual Return in Excess of Riskless Rate 8.xx% 10.xx% 13.xx%

Step 1

D CAPM Return in Excess of Riskless Rate 7.xx% 8.xx% 7.xx%

Step 2

E Size Premium (Return in Excess of CAPM) 0.xx% 1.xx% 6.xx%

Step 3

*Example: Calculate the 1926--XXXX Micro-Cap size premium from the table above. *This is a hypothetical example and does not use accurate data. Please do not use this data. Assumptions: · · · The historical long-horizon equity risk calculated over the time period 1926--XXXX is 7.xx percent. The historical riskless rate is the arithmetic mean of the income return component of 20-year U.S. government bonds over the time period 1926--XXXX, 5.xx percent. -

Step 1---- calculate the ``Actual Return in Excess of Riskless Rate'' (column C) Actual Return in Excess of Riskless Rate = (Arithmetic Mean Return -- Riskless Rate) = (Column B -- 5.xx%) = (18.xx% -- 5.xx%) = 13.xx%

·

Step 2---- calculate the ``CAPM Return in Excess of Riskless Rate'' (column D) CAPM Return in Excess of Riskless Rate = (Beta x Equity Risk Premium) = x ERP = 1.xx x 7.xx = 7.xx%

·

Step 3---- calculate the size premium as the difference between the values calculated in Step 2 and Step 1 (column C minus column D in the table.) Size Premium Micro-Cap = Actual Return in Excess of Riskless Rate (Step 1) -- CAPM Return in Excess of Riskless Rate (Step 2) = 13.xx% -- 7.xx% = 6.xx% -

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Using Size Premia Size premia can be added directly to the results obtained using either the CAPM model or Buildup Method. Example: CAPM model:

k s = rf + ( s × ERP) + SP

where:

ks rf

= the cost of equity for company s;

= the expected return of the riskless asset;

s = the beta of the stock of company s; and ERP = the expected equity risk premium, or the amount by which investors expect the future return on equities to exceed

that on the riskless asset SP = size premium Example: Buildup Method:

k s = rf + ERP + SP

where:

k s = the cost of equity for company s; rf = the expected return of the riskless asset; ERP = the expected equity risk premium, or the amount by which investors expect the future return on equities to exceed

that on the riskless asset SP = size premium *NOTE: In the context of the Buildup Method, which contains no beta measure, we can re-insert a measure of systematic risk by including an industry risk premium in the model (see next page).

Size Decile Portfolios

Largest and Smallest Companies by Size Group The table ``Size Decile Portfolios of the NYSE/AMEX/NASDAQ* shows the historical breakpoints for each of the three size groupings as defined at the date of the original SBBI publications. Mid-cap stocks are defined as the aggregate of deciles 3--5. Low-cap stocks are defined as the aggregate of deciles 6--8. Micro-cap stocks are defined as the aggregate of deciles 9--10. *NOTE: In the 1999 and 2000 SBBI Valuation Edition Yearbooks the decile portfolios were composed of NYSE stocks only. Since 2001, the decile portfolios have been composed of deciles of the New York Stock Exchange, plus similar-sized AMEX and NASDAQ companies. Source of underlying returns and breakpoints for NYSE and NYSE/AMEX/NASDAQ deciles: ©2011 CRSP®, Center for Research in Security Prices. Graduate School of Business, The University of Chicago used with permission. All rights reserved. www.crsp.chicagogsb.edu.

Industry Premia Estimates

In order to incorporate a measure of systematic risk into a cost of equity estimate in the context of the Buildup Model, Ibbotson developed an industry premium methodology based upon a full information beta estimation process. The full information beta estimation process includes the proportionate risk of all companies that participate in a given industry. This approach seeks to include

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Methodology: SSBI Valuation Essentials

data from all companies participating in a given industry in the formation of an industry premium. While the full information approach is a complex cross-sectional regression, it is most important to note that company data is sales weighted so that its effect on the formation of an IRP estimate is only to the degree in which the firm participates in that industry. To make it through the screening process, a company must have at least 36 months of return data available, have sales greater than $1,000,000 in the most recent year, and have a market capitalization of at least $10,000 in the most recent month. At the industry level, only those industries that have at least 5 participants and have an aggregate beta between 0 and 3 are considered. Ibbotson first published Industry Risk Premia (IRP) estimates in the 2000 SBBI Valuation Edition Yearbook. Thus, each version of ``SBBI Valuation Essentials'' from 2000 to present contains IRP estimates. Industry Risk Premia (IRP) Data Availability by Version IRP estimates are included in all versions of ``SBBI Valuation Essentials'' with the exception of the 1999 version, although the number of companies used to calculate each IRP is included only from the 2001 version to present, and a full listing by name and ticker of the companies used to calculate each IRP (the ``Industry Premia Company List'') is included only from 2003 to present. For more information about the ``Industry Premia Company List'', see page 13. The following table summarizes IRP data availability by version:

1999 IRP Estimates SIC Code Classification Short Industry Description Number of Companies Used Industry Premia Company List

2000 X X X

2001 X X X X

2002 X X X X

2003 X X X X X 2003 to Present-All Available

The table ``Industry Premia Estimates'' includes industry premia estimates by Standard Industrial Classification (SIC) code, a short description of the industry, and the number of companies included in the calculations for each IRP estimate. The SIC is the statistical classification standard underlying all establishment-based Federal economic statistics classified by industry. The SIC is used to promote the comparability of establishment data describing various facets of the U.S. economy. The classification covers the entire field of economic activities and defines industries in accordance with the composition and structure of the economy. SIC codes are organized from one to four digits. A single digit SIC code will be the most general classification; a four-digit SIC code will be the most specific. In addition, any company appearing in a four-digit classification will also appear in the three-, two-, and single-digit classifications. For example, a company included in industry 2844 will also appear in industries 284, 28, and 2.

Industry Risk Premia Derivation Ibbotson's industry risk premium estimation methodology uses the following equation:

IRPi = ( RI i × ERP) - ERP

where:

IRPi RI i ERP

· · ·

= the expected industry risk premium for industry i, or the amount by which investors expect the future return of the industry to exceed the market as a whole; = the risk index for industry i; and = the expected equity risk premium An IRP of 0 implies that the industry has the same risk as the market. An IRP greater than 0 implies that the industry is riskier than the market. An IRP less than 0 implies that the industry is less risky than the market.

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Methodology: SSBI Valuation Essentials

Reason for Industry Premia Adjustments in Buildup Method · While the CAPM includes a measure of systematic risk (beta), the Buildup Method does not include a measure of systematic risk.

Recall that a modified CAPM (includes a size adjustment) cost of equity estimate is expressed as follows:

ks = rf + ( s × ERP) + SP

Also recall that the Buildup Method (also including a size adjustment) cost of equity estimate is expressed as follows:

k s = rs + ERP + SPs

where:

ks rf

= the cost of equity for company s; = the expected return of the riskless asset; = the beta of the stock of company s; = the expected equity risk premium, or the amount by which investors expect the future return on equities to exceed that on the riskless asset. = size premium for company s

s ERP

SPs

To reintroduce a measure of systematic risk (beta) in the Buildup Method, an industry risk premia (IRP) can be added:

k s = rf +ERP+ SP + IRP

Using Industry Risk Premia Industry premia are added to Buildup Method cost of equity estimates in order to re-introduce a measure of systematic risk into the model. When using the Buildup Method, the estimates found in the table ``Industry Premia Estimates'' can be added to the risk-free rate, equity risk premium, and size premium as follows to estimate a cost of equity:

k s = rf + ERP + SPs + IRPs

where:

ks rf ERP SPs IRPs

= the cost of equity for company s; = the expected return of the riskless asset; = the expected equity risk premium, or the amount by which investors expect the future return on equities to exceed that on the riskless asset. = size premium for company s = industry risk premium for company s

NOTE: Industry premia should not be added to a CAPM estimate. The CAPM model already includes a measure of systematic risk in the form of beta; including an industry premia would constitute double counting.

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Methodology: SSBI Valuation Essentials

Industry Premia Company List

Companies Used to Calculate Each Industry Risk Premium (IRP) In order to incorporate a measure of systematic risk into a cost of equity estimate n the context of the Buildup Model, Ibbotson developed and then began publishing Industry Risk Premia (IRP) estimates in the 2000 SBBI Valuation Edition Yearbook. Starting in 2001, Ibbotson also began including the number of companies included in each IRP calculation. However, to better understand and apply the industry risk premia data, many clients requested that the specific companies associated with each industry also be made available, and so with the SBBI Valuation Edition 2003 Yearbook, Ibbotson began publishing the ``Industry Premia Company List Report''. The ``Industry Premia Company List'' is included as a supplement to each ``SBBI Valuation Essentials'' from the 2003 version onward. Each ``Industry Premia Company List'' organizes industries by Standard Industrial Classification (SIC) and displays the names of all companies used to calculate each IRP estimate. It is important to understand that each report is a supplement to the specific ``SBBI Valuation Essentials'' in which it is found, and is not related to any other Ibbotson or Morningstar, Inc. publication. NOTE: Industry premia are formed using a ``full information'' approach. This approach seeks to include data from all companies participating in a given industry in the formation of an industry premium. While the full information approach is a complex crosssectional regression, it is most important to note that company data is sales-to-industry weighted so that its effect on the formation of an IRP estimate is only to the degree in which the firm participates in that industry. You will see companies included in each industry that may seem out of place. Do not be alarmed. Companies are impacting the industry premia only to the extent of their sales in an industry. Companies that have very little sales in an industry will only have a small impact on the industry premium for that industry, but nevertheless, they should be included to get a complete picture of that industry's risk. You will also notice that companies will participate in many different industries. Once again, this is due to their sales across different industries.

Long-Term and Intermediate-Term U.S. Government Bond Yields

Each SBBI Valuation Essentials includes long-and intermediate-term U.S. government bond yields from 1926 year-end through year-end of the year preceding the version year (the ``data through'' date). Example: the year-end long-and intermediate-term U.S. government bond yields presented in ``2003 SBBI Valuation Essentials'' cover the time period 1926--2002. Definition of Terms

Yield---- the internal rate of return that equates the bond's flat price with the stream of cash flows (coupons and principal) promised to the bondholder. Long-term government bond yield---- the yields reported for 1977--present were calculated from The Wall Street Journal. The yields for 1926--1976 were obtained from the Center for Research in Security Prices (CRSP) Government Bond File. Intermediate-term government bond yield---- the yields reported from 1987--present are calculated from The Wall Street Journal. For 1934--1986, yields were obtained from the Center for Research in Security Prices (CRSP) Government Bond File. Yields for 1926--1933 are estimates taken from Coleman, Fisher, and Ibbotson, Historical U.S. Treasury Yield Curves: 1926--1992 with 1994 update. -

Key Variables in Estimating the Cost of Capital

Each version of ``SBBI Valuation Essentials'' includes ``Key Variables in Estimating the Cost of Capital''. This widely used table includes: Yields

Long-term (20-year) U.S. Treasury Coupon Bond Yield---- the yield on the long-term government bond series is defined as the internal rate of return that equates the bond's flat price with the stream of cash flows (coupons and principal) promised to the bondholder. The yields reported for 1977-present were calculated from The Wall Street Journal. The yields for 1926-1976 were obtained from the CRSP Government Bond File.

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Methodology: SSBI Valuation Essentials

Intermediate-term (5-year) U.S. Treasury Coupon Note Yield---- the yield on an intermediate-term government bond is the internal rate of return that equates the bond's price with the stream of cash flows (coupons and principal) promised to the bondholder. The yields reported for the 1987-present are calculated from The Wall Street Journal. For 1934-1986, yields were obtained from the CRSP Government Bond File. Yields for 1926-1933 are estimates taken from Coleman, Fisher, and Ibbotson, Historical U.S. Treasury Yield Curves: 1926-1992 with 1994 update. Short-term (30-day) U.S. Treasury Bill Yield---- data from The Wall Street Journal are used for 1977-Present; the CRSP U.S. Government Bond File is the source from 1926 to 1976. Equity Risk Premia

Long-horizon expected equity risk premium (historical)---- Large company stock total returns minus long-term government bond income returns. Large company stocks are defined here as Standard and Poor's 500 Stock Composite Index® (S&P 500). Long-horizon expected equity risk premium (supply side)*---- historical equity risk premium minus price-to-earnings ratio calculated using three-year average earnings.

Intermediate-horizon expected equity risk premium (historical)---- large company stock total returns minus intermediate-term government bond returns.

Short-horizon expected equity risk premium (historical)---- large company stock total returns minus U.S. Treasury bill total returns. *NOTE: It is important to understand that all equity risk premia estimates in ``SBBI Valuation Essentials'', with the exception of the single long-horizon supply-side estimate that is included in the table ``Key Variables in Estimating the Cost of Capital'', are calculated using the historical model. Size Premia by Size Groupings*

Mid-Cap---- the portfolio of stocks comprised of the 3--5th deciles of the New York Stock Exchange, including similar-sized AMEX and NASDAQ companies.

Low-Cap---- the portfolio of stocks comprised of the 6--8th deciles of the New York Stock Exchange, including similar-sized AMEX and NASDAQ companies.

Micro-Cap---- the portfolio of stocks comprised of the 9--10th deciles of the New York Stock Exchange, including similar-sized AMEX and NASDAQ companies. Size Premia by Decile*

A Breakdown by Deciles 1--10---- formed by ranking the securities of the New York Stock Exchange by market capitalization, forming ten - portfolios, and then inserting similarly sized AMEX and NASDAQ securities into the ten portfolios.

A Breakdown of 10a and 10b---- the same methodology used to form deciles 1--10 is used to split the 10th decile into two parts: 10a and 10b, with 10b containing the smaller companies. This is equivalent to breaking the stocks down into 20 size groupings, with portfolios 19 and 20 representing 10a and 10b. Ibbotson first published the 10a, 10b breakdown in the 2001 SBBI Valuation Yearbook. A Breakdown of 10w, 10x, 10y, and 10z---- a continued breakdown of 10a and 10b so that the 10th decile is split into four parts: 10w, 10x, 10y, and 10z, with 10z containing the smaller companies. Similar to the breakdown of 10a and 10b, this would be equivalent to breaking the stocks down into 40 size groupings, with portfolios 37, 38, 39, and 40 representing 10w, 10x, 10y, and 10z, respectively. Ibbotson first published this more detailed breakdown of the 10th decile in the 2010 SBBI Valuation Yearbook. *NOTE: In the 1999 and 2000 SBBI Valuation Yearbooks the decile portfolios were composed of NYSE stocks only. Since 2001, the decile portfolios have been composed of deciles of the New York Stock Exchange, plus similar-sized AMEX and NASDAQ companies. Source of underlying returns and breakpoints for NYSE and NYSE/AMEX/NASDAQ deciles: ©2011 CRSP®, Center for Research in Security Prices. Graduate School of Business, The University of Chicago used with permission. All rights reserved. www.crsp.chicagogsb.edu.

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Methodology: SSBI Valuation Essentials

Appendix

The SBBI Valuation Essentials Module contains the essential valuation data and analysis from each of Ibbotson Associates® SBBI Valuation Edition Yearbooks (1999-Present). IRS Revenue Ruling 59-60 changed the way business is valued and is the cornerstone of the valuation process. Among other things, Ruling 59-60 states that valuation is a forward-looking process but must be based on facts available as of the required date of appraisal. Some carry this out to the letter of the law and assume that only data available as of the relevant valuation date should be used. Others claim that events happening after the valuation date can be considered relevant if they were reasonably foreseeable as of the valuation date. The Stocks, Bonds, Bills, and Inflation Valuation Edition Yearbook and the web-based Cost of Capital Resource Center's SBBI Valuation Essentials Module provide data critical to the valuation process as far back as 1926, such as the equity risk premia and size premia presented in the large wedge-shaped tables that enable users to customize their analysis by selecting any start and any end date. These large tables can be used to develop a cost of equity as of a previous date. Assuming that the historical data presented in these large tables was available to the public as of the date of valuation, then many people would argue that the data from the current versions can be used in valuations as of a previous date. Others would argue that only versions published as of the valuation date are appropriate. It is up to the valuation practitioner to decide whether to use a current version with data from prior years or whether a version published as of the valuation date is the appropriate resource. It is also important to be cognizant of the fact that data revisions, although generally rare, can and do occur. Note: There are two examples for both the Buildup Method and the CAPM; one example each within the date range for which there are versions of ``SBBI Valuation Essentials'' available (1999--present), and one example each prior to 1999. Also note that the ``historical'' equity risk premium is used in all examples. Buildup Method Example Estimate a cost of equity in any year from 1999--present, making an adjustment for both size and industry risk. Since the valuation date falls within the time span 1999--present, the analyst may refer to the tables ``Key Variables in Estimating the Cost of Capital'' and ``Industry Premia Estimates'' from the appropriate version of ``SBBI Valuation Essentials''. The table ``Key Variable in Estimating the Cost of Capital'' is found on the last page of each version of ``SBBI Valuation Essentials''; consult the appropriate version's table of contents to locate the table ``Industry Premia Estimates''. Assumptions: · · · The valuation date is December 31, 2006, The company operates in SIC Code 36, the Electronic and Other Electrical Equipment industry, and The company has a market capitalization of $500 million.

The company falls within the Micro-Cap category based on a market cap of $500 million. Recall that each version of ``SBBI Valuation Essentials'' contains information from 1926 through year-end of the year preceding the version year (the ``data through'' date).

Example: the ``2007 SBBI Valuation Essentials'' contains information over the time period 1926 through year-end 2006. The steps needed for estimating the cost of equity using the Buildup Method are: · · Step 1---- locate the long-term risk-free rate Source: ``Key Variables in Estimating the Cost of Capital'' Step 2---- locate the expected long-horizon equity risk premium (historical) Source: ``Key Variables in Estimating the Cost of Capital

15 Methodology: SSBI Valuation Essentials

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· ·

Step 3---- locate the Micro-Cap size premium Source: ``Key Variables in Estimating the Cost of Capital'' Step 4---- locate the appropriate industry risk premium for SIC code 36 Source: ``Industry Premia Estimates''

Using the Buildup Method equation, the cost of equity estimate for the company in Buildup Method Example is:

k s = r f + ERP + SP + IRP

Some analysts may wish to make additional adjustments beyond the size and industry risk adjustments shown in this example.

CAPM Example Estimate a cost of equity in any year from 1999--present, making an adjustment for both size and industry risk. Since the valuation date falls within the time span 1999--present, the analyst may refer to the tables ``Key Variables in Estimating the Cost of Capital'' from the appropriate version of ``SBBI Valuation Essentials''. The table ``Key Variable in Estimating the Cost of Capital'' is found on the last page of each version of ``SBBI Valuation Essentials''. Assumptions: · · · The valuation date is December 31, 2006, The company operates in SIC Code 36, the Electronic and Other Electrical Equipment industry, The company has a market capitalization of $700 million.

Recall that each version of ``SBBI Valuation Essentials'' contains information from 1926 through year-end of the year preceding the version year (the ``data through'' date). Example: the ``2007 SBBI Valuation Essentials'' contains information over the time period 1926 through year-end 2006. The company falls within the Low-Cap category based upon a market cap of $700 million. The steps needed for estimating the cost of equity using the Buildup Method are: · · · · Step 1---- locate the long-term risk-free rate Source: ``Key Variables in Estimating the Cost of Capital'' Step 2---- locate the expected long-horizon equity risk premium (historical) Source: ``Key Variables in Estimating the Cost of Capital'' Step 3---- locate the Low-Cap size premium Source: ``Key Variables in Estimating the Cost of Capital'' Step 4---- Choose or estimate an industry beta Source: Full information beta for SIC 36 as of December, XXXX.*

* The data is only meant to serve as an illustration of the concept, and should not be used for any business decision making purposes. *NOTE: The CAPM also requires a measure of systematic risk, also known as beta ( ). One source of industry betas is the Morningstar Cost of Capital Resource Center's Company Betas Module, which includes industry betas calculated using a ``full information'' approach from December 1996 through present (semi-annually, as published in Ibbotson's Beta Book). This approach seeks

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Methodology: SSBI Valuation Essentials

to include data from all companies participating in a given industry in the formation of industry betas. While the full information approach is a complex cross-sectional regression, it is most important to note that company data is sales weighted so that its effect on the formation of industry beta is only to the degree in which the firm participates in that industry. Using the modified CAPM equation, the cost of equity estimate for the company in CAPM Example is:

k s = rf + ( × ERP) + SP = 4.x% + (2.xx × 7.x%) + 1.x% = 21.x%

Some analysts may wish to make adjustments to their cost of equity estimate in addition to the size adjustment shown above.

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Methodology: SSBI Valuation Essentials

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