In-Depth Page 1

Equity Research
Global

Investment Review

Trevor Harris <no subject> August 2, 2004

+1 (1)212 761 4713

ModelWare (ver. 1.0): A

Trevor.Harris@morganstanley.com

Guy Weyns
+1 (44) 20 7425 7979
Guy.Weyns@morganstanley.com Road Map for Investors
Juliet Estridge • A new standard for global consistency…
Elmer H. Huh Morgan Stanley’s proprietary framework brings transparency and
Sheelagh McCaughey comparability to our industry analysts’ 1,800+ models worldwide.
John McCormack • …with greater speed and flexibility by separating data from calculations
Leon Michaelides Analysts and investors will be able to adapt measures to their own
Catherine Loh needs…and quickly produce more reliable comps, both between
Michelle Teitsch companies and across sectors and regions.
• Investors have a robust new data base, built on rigorously defined metrics
Our global sector teams standardize calculations based on economic
logic, not arbitrary accounting rules.
• A critical look at the measures analysts and investors use and need
In this report: detailed descriptions of key performance ratios, price-
based multiples, and their components — a guide for anyone who
analyzes companies.

Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should
be aware that the firm may have a conflict of interest that could affect the objectivity of this report. This report should be
only a single factor in making their investment decision. Customers of Morgan Stanley in the United States can receive
independent, third-party research on the company or companies covered in this report, at no cost to them, where such
research is available. Customers can access this independent research at www.morganstanley.com/equityresearch or can
call 800-624-2063 to request a copy of this research

Please see analyst certification and other important disclosures starting on page 57.

Introduction to
We are delighted to introduce Morgan Stanley ModelWare,
a proprietary system for meaningful comparative analysis.
ModelWare represents a fundamental change in our
research offering; it is the first step in transforming the
analytical process at Morgan Stanley.
Over the last 18 months, under the guidance of Trevor
Harris and his team, our analysts have created a powerful
new framework of globally comparable forecast measures.
These rigorously defined financial metrics default to
economic logic, rather than favoring one accounting rule
over another, to set a new standard for high-quality comps
across sectors and regions. The consistency of these
metrics represents a major benefit. Yet the ModelWare
platform is also flexible: It will allow analysts and clients
to add or change data elements, develop their own
measures, and customize, quickly and easily, their own
individual analytical approaches.
What makes the ModelWare architecture distinctive lies in
the separation of data from calculations. Its transparency
will permit users to see every component of every
calculation, to choose elements or recombine them as they
wish. So instead of spending 80% of the time tracking
down data and making sure they’re consistent — and 20%
thinking about what they mean — ModelWare lets you do
the reverse. ModelWare frees analysts and investors to
focus on asking questions and finding new insights into
what creates value.
At the heart of financial analysis is determining relative
value. But without common definitions, global
comparisons are useless. ModelWare uses highly flexible
tools to compare projected financial performance without
laborious adjustments for varying accounting systems and
ModelWare – August 2, 2004
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Page 2
presentation formats. Our analysts have populated the
database with over 2.5 million data points, based on an
extensive taxonomy of more than 3,500 unique metrics and
more than 400 Morgan Stanley calculations. The
commitment to consistency and transparency in this
technology extends to new systems to check the internal
consistency of forecast data in each of our analyst’s
models.
After a systematic review by all Morgan Stanley analysts,
our company models are much more focused on how
forecast data portray the underlying economics of a firm.
Building on the initial ModelWare requirement of
integrated financial statements, analysts will be able to use
the additional data and tools to create more realistic
comparative analysis, prompting new questions… and new
insights into the issues driving stock prices.
ModelWare is far more than just another data base. And
even the best research platform in the world adds little
without the judgment and skill of the analysts. ModelWare
was designed to provoke questions, and the analysts who
have been using it will tell you it has already helped them
clarify their assumptions, build better forecasts, and think
about returns in a new way.
We hope you will take the time to become familiar with the
ModelWare framework. Your comments, questions, and
specific interests will help us enhance future versions.
Research Senior Management Team
Dennis Shea (New York) Toru Nagai (Tokyo)
Elizabeth Lynch (New York) Robert Feldman (Tokyo)
Jack Mueller (New York) Marcus Walsh (Hong Kong)
Juan-Luis Perez (London)
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Contents
Morgan Stanley ModelWare (ver. 1.0): A Road Map for Investors ...............................................................................................5
ModelWare Valuation and Performance Measures: An Overview .......................................................................................11
Price/Earnings (ModelWare)..................................................................................................................................................12
PEG (Price to Earnings and Growth) .....................................................................................................................................14
EV/EBITDA...........................................................................................................................................................................15
NOPAT or PTOP Margin (a.k.a. Operating Margin) ............................................................................................................16
Operating Asset Turnover (OpATO)......................................................................................................................................17
Return on Net Operating Assets (RNOA) (often a.k.a. ROIC) ..............................................................................................18
Leverage and Debt/Capital .....................................................................................................................................................19
Return on Equity (ROE).........................................................................................................................................................20
Dividend Payout Ratio and Dividend Yield ...........................................................................................................................21
Return of Capital Ratio and Yield (Gross and Net)................................................................................................................22
Price/Book (P/B) and Price to Tangible Book Value .............................................................................................................23
ModelWare Calculations: An Overview...................................................................................................................................24
Operating Revenue (OpR)......................................................................................................................................................25
Operating Expense (OpE)......................................................................................................................................................26
Pre- Tax Operating Profit (PTOP)..........................................................................................................................................29
Net Operating Profit After Tax (NOPAT)..............................................................................................................................31
Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) ..........................................................................32
Earnings Before Interest, Depreciation, and Amortization (EBIDA).....................................................................................33
Net Financial Income/(Expense) (NFE) .................................................................................................................................34
Other Income (Expense).........................................................................................................................................................36
ModelWare Net Income (a.k.a. ModelWare Earnings) ..........................................................................................................37
Net Income (Reported) (a.k.a. Earnings [Reported])..............................................................................................................39
Diluted Earnings per Share (EPS) ..........................................................................................................................................40
Basic Earnings per Share........................................................................................................................................................42
Free Cash Flow to Equity Holders for Cash Flow Yield (FCFfY) .........................................................................................43
Free Cash Flow per Share Diluted..........................................................................................................................................45
Free Cash Flow to Equity Holders for DCF (FCFDCF).........................................................................................................46
Net Operating Assets (NOA)..................................................................................................................................................47
Net Debt .................................................................................................................................................................................50
Other Non-Operating Assets (Liabilities)...............................................................................................................................51
Shareholders’ Equity ..............................................................................................................................................................52
Dividends per Share ...............................................................................................................................................................53
Return of Capital (Gross and Net)..........................................................................................................................................54
Market Capitalization and Market Capitalization Basic.........................................................................................................55
Enterprise Value (EV) ............................................................................................................................................................56

Modelware– August 2, 2004

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Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Morgan Stanley ModelWare (ver. 1.0):
A Road Map for Investors
ModelWare brings order to chaos. Investors and
managers alike have long sought better tools to view the
past and anticipated performance of an enterprise, using
both absolute and relative measures. Such metrics are
needed for projections, valuation, performance
measurement, credit analysis, taxation, capital budgeting,
debt covenants, and bonus payments, among many other
uses. Yet can there be any single measure that suits all
these needs, given changing economic conditions and limits
to both data and time? Unfortunately, no. Investors want to
use different measures for different purposes.
We have participated in countless hours of discussion with
our analysts over the “correct” way to calculate just about
any measure you could name, including sales, cash flow —
and even cash! Although unanimity is truly an unattainable
goal, the approach we have taken to setting common metrics
sets a new standard. We developed our philosophy for
ModelWare based on the following principles:
• using comparability as a guiding objective;
• emphasizing forecast over historical data;
• offering a standardized approach to common metrics;
• using economic logic to set a “norm”; and
• providing measures that are transparent in construction
but offer sufficient flexibility for our clients so they can
adapt measures to their own needs.
As clients’ demands and regulations change, ModelWare is
a work in progress. What you see today (as version 1.0) is
subject to constant evolution and enhancement; we invite
your detailed comments on the industry models you
encounter in the weeks ahead.
ModelWare: not just a data base, but a
powerful new set of globally comparable
and transparent metrics…and the tools to
use them
Look for the transparent label. From the outset of this
project more than 18 months ago, we have sought to define
measures that accurately reflect the underlying economics
of a firm — and to employ labels that provide maximum
transparency. We no longer use the misleading term “cash
Modelware– August 2, 2004
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Page 5
earnings,” for example. What many people call “cash
earnings” was earnings plus depreciation and amortization
— which is never a measure of cash flow or “economic”
earnings. (We can create calculations using these
underlying components, as clients require, but this means
employing new labels to retain the goal of transparency.)
As another example, our definition of net operating profit
after tax (NOPAT) uses our calculation that excludes all
interest on pension obligations and expected returns on
pension assets as non-operating. Some clients, however,
may prefer to look at these on a reported basis. Such a
different calculation is easily created, but it will not be
labeled NOPAT in the ModelWare system.
A third example, which shows how we address the need for
comparability, concerns how to represent earnings before
interest, taxes, and goodwill amortization. In the US, where
goodwill is no longer amortized, this is equivalent to EBIT.
EBITA would be misleading: It suggests that amortization
of other intangibles would be added back. Yet in the UK or
other countries where for now goodwill is still amortized,
EBIT is assumed to be after amortization. To be transparent
— and avoid a potentially endless debate — we created the
measure Pre-Tax Operating Profit (PTOP), the pre-tax
equivalent of NOPAT and equivalent to what many clients
think of as EBIT in the US and EBITA in the UK. (Clients
will be able to easily create the label they want, make it
equivalent to PTOP or not, exactly as each client chooses.)
For all these decisions, we have worked with the analysts
and relied on many years of collective experience and
consideration of the state of the art. When choices need to
be made, we take a forward-looking investment perspective.
In the following pages we describe the thinking behind
certain of the measures. We will adjust these definitions as
our clients point out issues and as available data and
regulations change. Inasmuch as our starting point is
economic reasoning, however, we expect that the
information captured will only improve over time.
What is ModelWare?
Simply stated, ModelWare is a database of company-
specific metrics drawn electronically from our analysts’
models, a set of universally defined calculations applied to

the data, and ultimately a group of software tools that will
allow users to slice and dice the data at will. But we also
use the term “ModelWare” to describe a rigorous process of
analytical review. During the last 18 months, our analysts
have spent an enormous amount of time re-evaluating and
refining their models, work that has already produced new
investment ideas and laid the foundation for future analysis.
Our approach in ModelWare is to consider what facilitates
sustainable revenue and earnings growth — the key factors
many investors seek to understand. To measure this
accurately requires detailed focus on the underlying
economics of reported and forecast items, not necessarily
those dictated by precedent or accounting convention. Our
analysts reconsidered how the most important metrics in
more than 1,800 models correspond with the economics of
what they want to measure. The correspondence, and the
final results, will not be perfect: Both remain subject to the
quality of an analyst’s work and insights, as well as the
often severe limitation of company disclosures. Different
investors may also require different approaches. But our
review has raised important new questions that have already
given valuable insights into virtually every sector.
The first step in understanding the ModelWare framework
is becoming familiar with our system of classification.
Analysts must label all income statement items, assets,
liabilities, and cash flows as “operating,” “financing,” or
“other.” This allows analysis to focus on the operating
performance of a company independent from its financing
decisions and other items that could distort operating
metrics. We often look to the division of responsibility
within a company (i.e., between operating and financing
managers) to help guide our classifications.
Exhibit 1 on the facing page, adapted from our “Apples to
Apples Earnings Monitor,” shows the starting point for our
development of the most important calculations. Beginning
with the basic components of modeled, integrated financial
statements, summarized on the left side of the ModelWare
Profitability Tree, we tagged hundreds of basic elements
that make up the revenues, expenses, assets, liabilities, and
cash flows in every model. By doing so, we can aggregate
the components consistently across all sectors to ensure that
distinctions between operating and financing activities,
useful for assessing sustainability and growth of income,
and performance measures like ROE — and earnings and
profitability measures like EPS, operating margins, and
operating asset turnover — are calculated consistently.
Modelware– August 2, 2004
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Does ModelWare Really Change What You Care About?
The answer varies but in many cases is a resounding yes.
The specifics will become clearer as our sector leaders and
analysts start to use and discuss metrics based on
ModelWare. In Exhibit 2 we use one example, Verizon,
covered by telecom analyst Simon Flannery, to illustrate the
potential impact for a single company.
Pre-ModelWare, Simon’s recently updated Verizon model
had pre-tax operating profits (and margins) of $16.2 billion
(23.9%) in 2003A and $16.4 billion (23.1%) for 2004E.
The post-ModelWare measures are significantly lower, at
$13.7 billion (20.2%) in 2003A and $15.0 billion (21.1%)
for 2004E, but the rate of improvement is much higher
under ModelWare than on a more traditional basis. In fact,
before Verizon’s recent earnings release and Simon’s
revision of his estimates, PTOP and operating margin
declined in his model between 2003 and 2004E on a pre-
ModelWare basis — but rose on a post-ModelWare basis.
A primary reason for the difference between pre- and post-
ModelWare operating profit is that ModelWare treats the
return on net retirement assets/obligations as a financing
rather than an operating cost.
Similarly, on a pre-ModelWare basis Simon had 12.1% for
ROIC (RNOA) and 5.5x for EV/EBITDA in 2003A, and
12.6% and 5.8x, respectively, in 2004E. Post-ModelWare,
Simon has 5.7% RNOA and 6.2x EV/EBITDA in 2003A
and 6.3% and 6.2x for 2004E. While the level of RNOA is
lower, the improving return on invested capital from
operating leverage is more dramatic under ModelWare,
which includes unrecorded goodwill from acquisitions. Yet
ROE is declining from 2003 to 2004E, and the level of
2004E ROE falls from around 20% pre-ModelWare to
under 10% post-ModelWare — indicating that the financing
of the business and capital structure merits investors’
attention. This rearrangement of operating and financing
activity should allow investors to better understand the
sources and sustainability of growth critical to making
appropriate valuation and pricing calls.
How are post-ModelWare measures different?
We would emphasize two main areas of change under
ModelWare. First, we are making the metrics consistent.
Pre-ModelWare, each analyst has had discretion in
calculating and labeling any metric. For example, invested
capital in ROIC might be equity plus debt, equity plus net
debt, operating assets, net operating assets; it might include
minority interests or not; and so on. Post-ModelWare, we
have standardized the components of the calculation, and
this will often lead to some change. Second, we are actually
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Exhibit 1
The Morgan Stanley ModelWare Profitability Tree
Operating Revenue NOPAT
Pre-Tax Operating NOPAT
-Operating Expense Net Operating Operating Revenue
Profit (PTOP) Margin
+ Other Operating Profit After Tax Return on Net
Income/(Expense) - Tax on Operating Profit
(NOPAT) Operating *
Assets Operating
Net Financing Net Financial
Financing Income Modelware (RNOA) Asset Operating Revenue
Income/(Expense) Pretax Income/(Expense)
- Financing Expense Earnings Turnover NOA
-Tax on Net Financing Income (NFE)
(OPATO)

Other Other Income/ Other

Non-Operating (Expense) Pre-Tax Income/Expense
Income/(Expense) Net Debt
Other Net Tax Expense Leverage
Shareholders’ Equity
Return on Equity Return from
(ROE) Leverage *
Financing RNOA –
Net Spread
Operating Assets Net Borrowing Cost
Operating
- Operating Liabilities Assets
(NOA)

+ Other Net
- Financial Assets Shareholders’ ONOAL
+ Financial Obligations Net Debt Equity Funding
Ratio Shareholders’ Equity
+
Return on Net
Other
Other Items *
Non-Operating
+ Other Non-Operating Assets Assets Other RNOA –
- Other Non-Operating Liabilities (Liabilities) Spread Return on ONOAL
- Minority Interests (ONOAL)

Exhibit 2
Pre- versus Post-ModelWare: the Verizon Example
Pre-ModelWare F2003A F2004E F03/F04E # F03/F04E %
Pre-Tax Operating Profit 16,159 16,396 237 1.5%
PTOP Margin 23.9% 23.1% (0.7%) (3.1%)
OpATO 0.51 0.55 0.04 7.2%
RNOA (ROIC) 12.1% 12.6% 0.5% 4.5%
Debt / Total Capital 56.0% 52.6% (3.3%) (6.0%)
ROE 22.0% 20.1% (1.9%) (8.7%)
EV/EBITDA 5.5 5.8 0.3 5.6%
P/E 13.4 15.7 2.4 17.6%
Free Cash Flow Yield (FCFY) 10.8% 4.7% (6.1%) (56.2%)

Post-ModelWare F2003A F2004E F03/F04E # F03/F04E %

Pre-Tax Operating Profit 13,715 14,981 1,266 9.2%
PTOP Margin 20.2% 21.1% 0.9% 4.4%
OpATO 0.44 0.47 0.03 7.4%
RNOA (ROIC) 5.7% 6.3% 0.6% 10.7%
Debt / Total Capital 38.6% 36.3% (2.3%) (6.0%)
ROE 9.8% 9.6% (0.2%) (2.1%)
EV/EBITDA 6.2 6.2 0.0 0.4%
P/E 13.4 15.7 2.4 17.6%
Free Cash Flow Yield (FCFY) 8.3% 6.0% (2.2%) (27.2%)

Direction Direction
Pre- vs. Post-ModelWare F2003A # F2003A % of Adj. F2004E # F2004E % of Adj.
Pre-Tax Operating Profit (2,444) (15.1%) (1,414) (8.6%)
PTOP Margin (3.6%) (15.1%) (2.0%) (8.6%)
OpATO (0.07) (0.14) (0.08) (0.14)
RNOA (ROIC) (6.4%) (53.0%) (6.3%) (50.2%)
Debt / Total Capital (17.4%) (31.0%) (16.3%) (31.0%)
ROE (12.2%) (55.6%) (10.5%) (52.4%)
EV/EBITDA 0.6 11.7% 0.4 6.2%
P/E - 0.0%  0.0% 
Free Cash Flow Yield (FCFY) (2.6%) (23.7%) 1.3% 26.7%
Source: Morgan Stanley ModelWare Estimates

Modelware– August 2, 2004

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changing the calculations for some basic inputs on the left-
hand side of the ModelWare Profitability Tree. The
following examples give some idea of the issues involved.
Adjusting the models to get to operating revenue…
Revenue is where forecasts often begin. We accept the
usual description of this measure as the quantity of sales
(revenue) generated by the ongoing operating activity of a
firm, its people, and its resources. But digging below the
surface, we find a number of difficult choices that have to
be made. Under operating revenue, for example, we
exclude sales or volume discounts, where these data are
known. We also show revenue net of excise or value-added
taxes, discounts and receivables or loan loss provisions,
unless these are considered unusual (“one-time” or “non-
recurring). The logic is that their inclusion overstates the
actual activity and sustainable or collectible revenue.
Moreover, as many other items are often forecast as a
proportion of revenue, it is critical that unrelated items (like
taxes collected on behalf of a government) are excluded.
…And to get to operating expense…
Some more complicated adjustments are required in getting
to operating expense. Here, at the discretion of the analyst,
we eliminate non-recurring costs (net of tax). While
companies can easily treat ongoing expenditures as if they
are non-recurring, there is no simple “rule” to establish what
is recurring or not. However, ModelWare initially focuses
on forecast, not historical data. And good analysts tend to
be consistent in treating historical non-recurring items by
excluding them from forecast costs, margins, and the like.
Leasing is a financing decision: The notion of operating
leases is an aberration of current accounting rules. Using
operating leases not only leads to off-balance sheet
liabilities and understated operating assets but also allows
operating costs to be distorted, by including borrowing costs
in operating expenses and creating inconsistent treatments
of the cost of operating assets, solely as a result of financing
decisions and accounting rules.
ModelWare addresses this problem by treating all non-
cancelable leases as purchased assets, financed with debt.
As a result of the adjustments, in the early stages of leased
assets, we usually find operating income rises, net income
falls, and operating assets increase — but by less the net
debt increased. These trends, especially for earnings, will
reverse over time unless investments in new leased assets
increase. The important takeaway is that the post-
ModelWare data are a more accurate depiction of the actual
Modelware– August 2, 2004
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performance of the business, especially when comparing
results across companies or time periods.
Operating leases are an aberration of
current accounting rules: ModelWare
treats all non-cancelable leases as
purchased assets financed with debt.
But putting all leases on a consistent basis is complicated by
limited data, and by varying degrees of leasing activity
across sectors. Because our primary objectives are
comparability and transparency, we have initially allowed
our global sector leaders to decide if their teams should
capitalize operating leases when material amounts of
operating leases distort comparisons. The adjustment
represents a major change for certain companies — and has
prompted considerable debate and new questions among our
analysts. To date, our retail and transportation teams have
chosen to make this adjustment; others will follow, we
believe, as clients get more comfortable with the relevance
of the adjustment. We also anticipate that accounting
regulators will address this issue before long and decide to
capitalize operating leases, as we have done.
…And to pin down profitability measures…
Associated companies pose a special problem in measuring
pretax operating profit, or PTOP. A classic example is
Coca-Cola (KO) and its bottlers, such as Coke-Amatil. KO
owns less than 50% in the bottler and so does not
consolidate it, yet the two companies share many operating
activities. Nestlé and its investment in L’Oréal are very
different: L’Oréal’s operations are run independently of
Nestlé’s; even though the latter’s significant investment can
have a big impact on the value of its stock. In the case of
KO and Amatil, we classify the equity income as
“operating” and include it in PTOP. But we include the
equity income from Nestlé’s investment in L’Oréal in non-
operating income. (We also provide a metric that excludes
the equity value of the investment, for price-based
multiples.)
Adjusting for taxation when comparing companies on the
basis of after-tax net operating profit, or NOPAT, is a
challenge. Our solution: For the net operating and
financing income, we use the annual statutory tax rate a
company would pay given the mix of regions in which it
operates. Consider a company with 80% of its operations in
a country that has a national (federal) rate of 35% and in
areas where state and city tax rates add another 5%. The

remaining 20% of operations are in a region with a 20% tax
rate (and these earnings are not taxable in the parent’s
region at the higher rate). We would calculate a statutory
rate as follows:
(0.8*(35%+5%)) + (0.2*20%) = 36%
This rate is then applied to PTOP less any known non-
taxable components of PTOP. The statutory rate will
change if the mix of regions changes in the future or if the
regional rates change.
EBITDA is not at all the measure of operating cash flow
that some investors think, but the concept is still used.
Because we exclude returns on pension assets and interest
on pension obligations from PTOP (and hence EBITDA),
our measure of EBITDA may differ from others’. In many
countries, mainline telecom companies have sizable pension
schemes; if these are unfunded, EBITDA rises as interest
costs are eliminated (where pensions are funded, it could go
the other way).
Why do we do this? Consider a company that chose to
borrow $1 billion at 7% and invest it in its pension fund.
Under current accounting rules in the US and Japan and
available under IFRS, interest (financing cash cost) would
go up $70 million — but pension “costs” would appear to
decline by $80–90 million, as the average expected return of
8–9% on plan assets applied to the $1 billion gets deducted
from operating expense. Realistically, the higher interest
costs should be offset by the actual return on pension
investments: Both are financing choices. But as it is
usually measured, EBITDA would go up even though
economically such a choice reflects financing, not operating
skills. So any performance ratio or multiple using
unadjusted PTOP, NOPAT, or EBITDA would not be
reflecting operating performance.
…And cash flow calculations
When putting ModelWare together, a surprise many of us
encountered was the difficulty of deriving valid cash flow
How ModelWare Treats Pensions
1. Adjusts balance sheet to recognize the net surplus or deficit
of health care and pension obligations without deferrals.
2. Treats net obligations as debt.
3. Classifies net interest portion of the net pension obligation
as financial cost, not operating expense.
4. Treats related deferred taxes as financing, not operating.
Modelware– August 2, 2004
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Page 9
calculations from public disclosures. The problem arises in
linking accruals in earnings (e.g., in operating revenues and
expenses) with the related balance sheet accounts (like
receivables and provisions). There is also considerable
opacity in attributing taxes to various activities, especially
with complex deferred tax measurements, making measures
of real free cash flow — and especially free cash flow from
operations — subject to potential measurement problems.
In forecasts, analysts usually presume that changes in the
balance sheet accounts are sources or uses of cash and then
adjust the related earnings measure for these. We have
taken this approach for forecast data, but this simply does
not work for actual data. Reasons include foreign currency
translation and acquisition-related activities that affect
changes in balance sheets but have no real cash flow impact,
as well as company adjustments for non-cash items that are
opaque to investors and analysts. So as a starting point,
ModelWare’s historical cash flow measures rely on the data
in actual statements of cash flow provided by companies.
Our approach to counting cash… We reflect both free
cash flow for DCF valuations and the (free) cash flow
measure relevant for free cash flow yield, which has gained
in popularity among investors. This measure includes cash
from operating activity, (net) debt service, and other
income- or expense-related cash flows, but excludes
changes in debt principal and new equity financing.
Finally, we allow analysts to identify a portion of capital
expenditures (i.e., investments in their operations) that are
considered to be for future growth, and exclude this “growth
capex” from the free cash flow for yield purposes. As
discussed in our earlier Apples to Apples reports, however,
spending on capacity to sustain current levels of revenue is
not “growth” capital expenditure. So-called “required
capex,” such as retooling plants to face increased
competition or shorter product life cycles, must be treated as
an annually recurring cash outflow.
This approach reflects our objective of providing a measure
of “sustainable” free cash flow that is implicit in calculating
free cash flow yield. Given the high levels of
capex/depreciation ratios relative to anticipated growth we
have observed over time in most regions and sectors, the
default is to use the current capex as required capex. As
analysts retain the ability to define the growth capex as they
see fit, we expect the process of identifying growth capex to
evolve — especially as analysts and investors consider the
appropriate treatment. In any case, ModelWare users will

be able to adjust the exclusion of growth capex, if the
analyst has identified any.
…and adjusting the ‘cash’ in cash flow yields. Free cash
flow yield has become a popular measure, because many
people think that cash flows do not have measurement
problems, that “cash is cash.” For the cash that a
shareholder can actually take to the bank, this is true, but
unfortunately, for all other measures of a firm’s cash flow,
the measurement issues can be tough. Consider the case of
an economic cost that does not require the use of cash in
that period, say, interest on a zero-coupon bond. In the
years before maturity of the bond, there is no cash “paid,”
because it is being borrowed and added to the principal debt
balance. So should this charge be treated as non-cash for
free cash flow yield purposes?
The cash flow will occur when the debt is repaid, but free
cash flow for yield purposes excludes any debt repayment.
If we exclude this interest cost, it would be as if the interest
has no cash cost to shareholders — but it clearly does. So
while some users of free cash flow yield may think such an
expense should be treated as non-cash, we argue it is a cash
equivalent and must be considered in the free cash flow
yield calculation. Other costs that require similar treatment
include pension-related costs and share-based payments for
employee or like costs.
Would direct cash flow statements help with forecasts?
Accounting rules provide cash flow statements that consist
of operating, investing and financing components. But
these distinctions are difficult to make consistently, and in
ModelWare we could not come up with a practical use for
them. For example, investments in capacity may be lumpy,
but they are part of operations. Similarly, interest is
included in operating cash flows under US GAAP but is
clearly financing in nature. Then there is the capitalized
interest or interest cost that accrues on a deep discount bond,
where classification becomes even trickier. The treatment
of taxation is particularly troublesome as some items are
reflected in earnings or changes in equity net of tax, so
getting a cash tax “expense” has questionable meaning.
And tax can apply to operating, financing and investment
items, yet there is nothing in the disclosures to identify the
cash, payable, or deferred portions of any of these.
Some investor advocates encourage regulators to replace the
indirect cash flow statement with a direct statement of cash
received from customers, paid to suppliers, etc. While this
Modelware– August 2, 2004
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Page 10
may be of some use in historical liquidity analysis, and help
reduce the morass of current cash flow disclosures, the final
cash flow numbers are the same, and we cannot find a way
to use direct cash flow categories in forecasting future cash
flows. In fact, it could make matters worse, if uninformed
users applied simple growth rates to these numbers, creating
even more misleading cash flow data. We therefore did not
try to recreate such data in any calculations for forecasts.
How about valuation and profitability measures? Our
aim is not simply to reorder financial statements but to
generate improved metrics relevant to fundamental analysis
and stock picking. Profitability measures like return on
invested capital can be confusing if we do not know what
goes into invested capital. ModelWare technology uses
return on net operating assets, which is derived from
consistent components tagged by the analysts; the
numerator in this calculation (operating income) is also
logically consistent with NOA, indicating the alignment of
the label with the underlying calculation.
While we have always been wary of relying on single-
period measures for valuation or investment decisions, we
recognize their common use. In the overview that follows,
we describe many of the problems that occur when
calculating valuation metrics. Even ratios as seemingly
simple as P/Es have measurement issues that can lead to
inconsistency and misperceptions of relative performance.
It is difficult enough to make sure that the earnings are
measured consistently, which we have begun to do in
ModelWare. But as the following section makes clear,
price is a per-share measure at a point in time, incorporating
the market’s expectations of future events, including
expected dilution in shares outstanding. Yet earnings per
share are based on a measure of average shares outstanding,
often very different from the shares outstanding embedded
in prices, especially if there is outstanding contingent equity
or expected share repurchases or issuances.
We try to deal with these issues in the measures that our
analysts have indicated our clients need. There will be
more measures to come, and we expect to learn more over
time, but our analysts have invested significant resources in
bringing more consistency, transparency and insight to our
analytical framework. In sum, our objective is to provide
simple, conceptually sound measures that meet the needs of
users and add to transparency. We want these to be “open
source” in nature, and we welcome your feedback.
 Page 11

Morgan Stanley ModelWare

Valuation and Performance Measures:
An Overview

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Price/Earnings (ModelWare)
What’s Measured
• Multiple of earnings that the market is willing to pay.
Typical Use
• P/E ratios are frequently used as a benchmark of
relative valuation.
• P/E ratios are sometimes used as a basis for the
absolute value of a stock, but this should only be done with
great caution. The implicit assumptions made in valuing a
company based on a single period’s earnings are extreme.
ModelWare Approach
• We assume that the share price factors in expected
dilution, so we use diluted ModelWare EPS as our primary
measure for P/E. However, we also provide P/E ratios for
basic, historical, or reported EPS and for other measures
insofar as clients request them.
• For historical P/E ratios, we use the price at the last
date of the period to which the earnings relate. If the year-
end is 31 December 2003, we will use the price closest to
that date for 2003 earnings. The reason is that later prices
(say, in 2004) are reflecting additional information for
events subsequent to 2003 earnings, so the meaning of a
P/E using 2004 prices and 2003 earnings is questionable.
This problem is exacerbated if the company returns any
capital to its shareholders (e.g., by paying a dividend), as
the cum-dividend price is the more appropriate measure to
use.
For forward P/E ratios, we use the latest price, divided by
forecast EPS.
Modelware– August 2, 2004
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Page 12
Underlying Economic Logic
Q Is there a “right” P/E ratio?
A Conceptually, if forecast annual earnings were
known to be sustainable and all reinvested capital
earned the cost of equity, then the P/E multiple should
be the reciprocal of the cost of equity. In fact, however,
this is almost never going to be the case because
profitability grows at different companies at different
rates, earnings are often not sustainable, and many
measurement issues with earnings abound.
Any valuation based on a single-period measure of
performance is doomed to be inaccurate and should be
treated with circumspection. It may have validity for
where a stock will trade for a short period, but it should
not be considered a measure of the value of a company.
NB P/E ratios are also distorted by the difficulty in
accurately measuring the shares used in both the
numerator and the denominator unless there are no
dilutive securities and no changes in the number of
shares outstanding during the period.
Q ModelWare EPS differ from what was used
earlier to “value” or “price” a stock: Does this
imply a change to the intrinsic value or price target?
A No absolute valuation measure or price target
should be based on a simple multiple of earnings unless
one is comfortable both that earnings are sustainable
and that all earnings growth derives solely from
reinvested capital earning a cost of capital. This is
rarely the case. However, for those who rely on P/E
multiples as the basis for price target or value, any
difference from existing earnings should be analyzed
carefully. As ModelWare earnings are focused more on
economic reality and comparability, the new multiple is
likely to be more meaningful.
continued
 Page 13

Price/Earnings (ModelWare) (continued)

Underlying Economic Logic

Q What price should be used in historical and future periods as earnings change?
A For historical periods we use the price (market capitalization) at the end of the period to which those earnings relate.
As the current price incorporates both past events that could have been after the measured equity (say two periods before)
and expectations about future events, we see no meaning in applying current prices to earnings in prior periods.
A Another problem that affects interpretation of historical P/Es is that the price will go down (all else equal) from
dividends; price is also affected by other changes in capital after the earnings, so the meaning of such P/Es is questionable.
A For forecast periods, we use the most current price. Given that price is supposed to reflect current expectations of the
future (on a present value basis), it seems too arbitrary to adjust prices without knowing what information is already in the
price.
NB There is an argument that the analysts’ target price could be used for one year ahead, or that the “future price” should
be the current price multiplied by 1+ cost of equity (per year), adjusted for returns of capital. Without showing the
assumptions, rates, and calculations, however, neither approach would support our objectives of transparency and
comparability. In addition, as expected shares outstanding may change in the future (e.g., from share repurchases),
adjusting becomes even more arbitrary.

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

PEG (Price to Earnings and Growth)
What’s Measured
• As growth is considered a missing factor in getting a
meaningful P/E, it is often assumed that dividing the P/E by
a growth rate controls for the impact of growth in price.
Typical Use
• PEG is often used in sectors with high growth rates as
an alternative to the P/E ratio. Uses are therefore the same
as indicated above for P/E.
ModelWare Approach
• As earnings growth can be created by changes in
invested capital, the typical use of nominal growth rates
unadjusted for the use of capital is seriously flawed.
However, to meet client requests, we use these nominal
growth rates over 1 and 3 years, but identify explicitly that
these are nominal 1- or 3-year PEG ratios.
Modelware– August 2, 2004
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Page 14
Underlying Economic Logic
Q Is there a “right” PEG ratio?
A As with P/Es, under some very strict conditions
there could be a conceptually valid ratio. But the
problems of comparability and measurement identified
in P/Es are compounded when growth rates are added,
because there is rarely a single rate that persists and the
rate of growth is a function of new capital deployed.
NB If two companies have the same growth rates but
the growth occurs at different points in time, then they
should not be valued equivalently. PEG ratios have no
way of separating these, because they rely on just two
factors.
NB If two companies have the same growth rates, but
one company’s growth comes from reinvested or newly
raised capital and the other grows organically (from
operating leverage), they should be valued quite
differently. Consider two companies starting with $10
million dollars of capital and a 10% rate of return and
discount rate. The earnings in year 1 will be $1 million
for both companies. Company A retains all its earnings
(free cash flow) and earns 10% on the new capital.
Company B pays all its earnings back to the
shareholders but gets operating leverage and earns 11%
in year 2. In year 2, A has capital of $11 million and
earns $1.1 million, for nominal earnings growth of
10%. B still has only $10 million of capital but with its
organic growth earns $1.1 million, also nominal 10%
growth. At the start of year 1 and even in year 2, before
the dividend is paid, companies A and B have different
intrinsic values (ignoring taxes on dividends), and B is
worth more than A.
If deploying new capital earns a positive return
above the cost of capital, earnings growth adds value.
But if the rate of return is below the cost of capital, a
company destroys value, and growth is actually a
negative for value — and usually the stock price as
well.

EV/EBITDA
What’s Measured
• The multiple of the value of the enterprise to pre-tax
operating income, excluding any capacity cost and cost of
amortizing intangible assets.
Typical Use
• EV/EBITDA is often used as a relative valuation metric,
assumed to be analogous to P/E but at the operating (entity)
level. However, it excludes any cost for capacity, an
operating cost that is often a key value driver in many
sectors. So we are very skeptical about the relevance of this
multiple as an indicator of relative value.
• EV/EBITDA is sometimes considered a measure of
Enterprise Value to “Operating Cash Flow.” We consider
this incorrect and misleading, because EBITDA is seldom a
good measure of actual operating cash flow (see discussion
of EBITDA, page 32).
ModelWare Approach
• See pages 56 and 32 for details about how we calculate
EV and EBITDA.
• In certain sectors, such as telecom, our analysts wanted
to show an EV/EBITDA measure that excludes the minority
stake of certain significant subsidiaries (especially for joint
ventures in the wireless sector). If detailed information is
available, this is done through a proportional consolidation
adjustment. When this detail does not exist, the analysts
define an approximate percentage to make the adjustment.
Both the EV and EBITDA measures are adjusted.
• If there are significant investments that affect market
capitalization but are treated as non-operating in nature, we
exclude the incremental value in equity of these investments
from the calculation of EV for the EV/EBITDA calculation.
Modelware– August 2, 2004
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Page 15
Underlying Economic Logic
Q If EV/EBITDA is considered an inappropriate
metric, why include it in ModelWare calculations?
A ModelWare is a tool for clients and analysts, and
there is still a demand for EV/EBITDA, so we want to
ensure that the measure used is consistently calculated.
This is particularly important as some investors and
analysts use it for relative valuation or pricing purposes.
ModelWare’s calculation of EV and EBITDA is
not the same as many people traditionally calculate it.
NB ModelWare treats net pension obligations as debt
in EV, and the net interest on this as financing, so it is
excluded from EBITDA. It also treats the present value
of remaining operating lease payments as debt and so
effectively excludes the rental payment from EBITDA,
as the imputed interest and depreciation are excluded
from EBITDA. In this first stage of ModelWare, only
our retail and transportation analysts are capitalizing
operating leases, but we expect this to expand over
time, especially when regulators head in the same
direction, as we expect.
Q How should EV/EBITDA be calculated when
considering historical or future periods?
A In all cases, using a measure of value at one point
in time and comparing it to a measure reflecting activity
over many periods introduces potential error. This
problem is compounded in EV/EBITDA, because EV is
inevitably a mix of market and book measures. But as
we need to supply a measure, we offer the following
solution. For historical periods, we would use the EV
measured on the last date of the period, because the
EBITDA is earned up to that point. For future periods,
as with P/E, the market capitalization should not
change, for it is too arbitrary to decide what future
events are already anticipated in the current price. A
similar argument would apply if the market values of
debt or other included items are used. But market value
of debt is rarely used in practice; our (uncomfortable)
compromise is that if book value is used, then the future
EV is adjusted for forecast book values. Our preference
would be to avoid using EV/EBITDA.
NB Clearly, EV/EBITDA needs to be interpreted
cautiously, especially when using future periods.

NOPAT or PTOP Margin (a.k.a. Operating Margin)
What’s Measured
• The percentage of revenue generated as operating profit.
• PTOP margin is the pretax measure; NOPAT margin
considers a tax charge at a statutory rate.
Typical Use
• Operating margin is used as a key metric of
performance and profitability of the business and the
operating management. It is then used to compare
competing enterprises.
• Operating margin is used to reflect how much of each
currency unit of revenue (e.g., dollar, euro, yen, sterling,
etc.) is generated as profit before financing and other non-
operating costs (and taxes, for PTOP margin).
• Operating margin is one of the two components of
Return on Net Operating Assets (a.k.a. Return on Invested
Capital or ROIC), which can be used to understand the
sources of operating leverage; see page 18.
ModelWare Approach
• See the detailed discussion of NOPAT and PTOP,
pages 31 and 29.
• We calculate the margin using the respective operating
profit measures divided by ModelWare operating revenue.
We use PTOP and NOPAT rather than operating income,
because of ambiguity in the definition of operating income
as used by companies, analysts and investors.
• As we classify as operating certain investments in
associate companies accounted for under the equity method,
the operating margins will be relatively higher, because
there is no specific revenue associated with these
investments, but the income is in PTOP and NOPAT.
Modelware– August 2, 2004
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Page 16
Underlying Economic Logic
Q How different is operating margin from gross
margin? Why not focus on gross margin instead?
A Gross margin is based on cost of sales or services
and related revenue. While we provide for this
calculation, we find too much variation in the way cost
of sales is reported to get a broadly consistent definition
of gross margin. For example, some companies
separate depreciation from other costs, and the
depreciation could apply to other costs, like selling and
administration costs, so it makes no sense to include
this in a cost of sales measure.
We believe that gross margin is an overused
metric, with little economic validity in most cases,
given the large variation in the ways companies allocate
costs between COGS and SG&A.
Q When should the pre- versus post-tax measure
of operating margin be used?
A This depends on the question being asked. If the
intent is to consider sustainable profitability in the
absence of financing decisions, the NOPAT margin is
usually more appropriate. We have also found that
excluding taxes entirely makes the separation of ROE
into its components as shown in the profitability tree
(Exhibit 1) much more difficult.
NB When using NOPAT margins, it is often important
to use a statutory rate rather than an “effective” tax rate.
Otherwise, the tax component, which is often affected
by financing activities, can distort the underlying
operating performance that is of interest (see discussion
of NOPAT).

Operating Asset Turnover (OpATO)
What’s Measured
• The revenue generated per unit of operating capital, or
investment in net operating assets.
Typical Use
• OpATO is a measure of capital or operating efficiency
and as such is another key metric of performance of the
business and operating management.
• OpATO is one of two components of Return on Net
Operating Assets (a.k.a. ROIC) used to assess operating
leverage.
ModelWare Approach
• We calculate OpATO as operating revenue (page 25)
divided by beginning of period net operating assets (page
47).
• As we classify certain investments in associate
companies accounted for under the equity method as
operating, OpATO will be relatively lower as there is no
specific revenue associated with these investments, and the
investment is included in NOA.
Modelware– August 2, 2004
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Page 17
Underlying Economic Logic
Q How does one decide which net assets to include
when calculating OpATO?
A This can be controversial, and we describe the
detail below. But the simple answer is to consider
which assets or obligations are being used to generate
the operating revenue in the numerator.
NB A practical approach is also to consider those assets
or obligations that are financing in nature, that is, those
managed by the finance and treasury managers, and any
other accounts that are clearly non-operating. All other
accounts are then considered operating.
In general, analysts have focused on revenue
growth without the same focus on the resources needed
to generate that growth. A pattern of continuously
improving OpATO is difficult to achieve, and such a
pattern for any company should always be considered
relative to its competitors’, as not everyone can “win.”

Return on Net Operating Assets (RNOA) (often a.k.a. ROIC)
What’s Measured
• The rate of profitability from the operating business.
Typical Use
• RNOA (or ROIC) is usually the primary measure used
to assess the operating profitability of a business.
• Comparing RNOA to the cost of capital illustrates the
extent to which the business is generating value from
operations for its stakeholders.
ModelWare Approach
• RNOA is calculated as NOPAT margin multiplied by
OpATO.
• ModelWare uses RNOA rather than ROIC as the notion
of invested capital is ambiguous. It could be considered at
an equity owners’ level as well as at an operating level, but
these would require different measures of invested capital.
By identifying that we are using net operating assets, we
can be transparent.
Modelware– August 2, 2004
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Page 18
Underlying Economic Logic
Q Why consider RNOA versus return on equity
(ROE)?
A We believe it is important to look at both. RNOA
is useful as an indicator of operating performance, but if
the capital structure has significant debt, then the cost
of that debt could eliminate any actual profit for the
shareholders. Yet ROE is affected by leverage, so
comparing ROE requires an assessment of relative risk.
NB While finance theory argues that funding with debt
(subject to tax issues) should be a matter of
indifference, it is hard in practice to get precise
estimates of the weighted average cost of capital over
time. So analyzing RNOA versus WACC needs to be
interpreted carefully.
Q Is RNOA relevant in sectors with low operating
asset bases?
A Yes! RNOA is the combination of operating
margin and OpATO. Low assets should mean high
turnover ratios, but that does not mitigate its use. In
particular, as a company evolves, it is often hard to
increase efficiency and can sometimes lead to declining
OpATO as companies seek new ways to grow.
NB Companies that have mastered outsourcing can
even end up with negative net operating assets as they
use suppliers to fund their limited inventory and
receivables. Dell Computer was a classic case of this.
In such cases, the RNOA metric needs to be interpreted
carefully. The direction of change is often most critical.
 Page 19

Leverage and Debt/Capital

What’s Measured Underlying Economic Logic

• Leverage is the ratio of debt funding relative to equity
funding.
• Debt/capital reflects the debt as a ratio of debt, equity
and minority interests, and shows the degree to which debt
funds operating activity.
Typical Use
• Leverage is used to assess credit risk and can be used as
a measure of liquidity.
• Leverage is also used to assess how capital structure
affects the calculation of ROE.
ModelWare Approach
• We calculate leverage as net debt divided by
shareholders’ equity (see pages 50 and 52), ensuring that the
period for which they are measured (beginning or ending) is
consistent for both measures.
• We calculate debt/capital as net debt divided the sum of
common equity, net debt, and minority interest in subsidiary
companies.
Q Why is leverage measured relative to
shareholders’ equity and not assets or net operating
assets?
A As we see in the profitability tree in Exhibit 1,
ModelWare creates calculations that facilitate a clear
mapping from the individual accounts to profitability
ratios. Leverage based on equity facilitates this
decomposition. We also decompose other non-
operating items relative to equity, which allows us to
see all forms of funding. If the other non-operating
items are net assets, then the leverage based on net
operating assets would not convey the real funding
from net debt. However, we also calculate debt/capital
to reflect the proportion of debt relative to other funding
sources.
NB While the use of leverage is theoretically value-
neutral, we believe that in practice, capital structure can
matter and create value. For example, General Electric
has for many years effectively borrowed at low nominal
interest rates and invested this capital in businesses with
higher RNOA, effectively creating wealth for its
shareholders.

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Return on Equity (ROE)
What’s Measured
• The percentage return on capital raised from or
reinvested by common shareholders.
Typical Use
• ROE is often used as a benchmark of how profitable a
company is, especially when compared to its cost of equity.
• ROE is often considered most useful in financial
services companies like banks, where capital and leverage
ratios tend to vary little. In all cases, however, a single
period’s measure should be used cautiously.
• ROE is also used a simple approach in the calculation
of residual income valuations.
ModelWare Approach
• The simplest approach we take is to use ModelWare
earnings divided by beginning shareholders’ equity. We
also calculate a return on average equity based on the
average of beginning and ending shareholders’ equity.
• Exhibit 1 shows how ROE can be decomposed into
RNOA and the effect of leverage (with an adjustment for
return on other non-operating items). This calculation is
also made and checked to equal the result of the simple
approach.
Modelware– August 2, 2004
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Page 20
Underlying Economic Logic
Q Why is beginning rather than ending
shareholders’ equity used to calculate ROE?
A The idea of ROE is to understand what profitability
has been generated from invested equity. Reinvested
earnings become part of equity and generate new
earnings. Using ending equity would unfairly reduce
ROE, inasmuch as capital (re)invested at the end of the
period has little chance to generate new earnings. It
might be argued that if significant new capital is
injected early in the year, the beginning equity is
unfairly overstated. This is why some people advocate
using an average. As with any single-period measure,
there are always potential distortions; the key is to use
the measure as a starting point and investigate further
where necessary. We always advise looking beyond a
single period for any metric.
NB A useful approach is to look at both ROE and ROE
(average); if there is a significant difference, it is worth
investigating when the new capital was invested.
Q How is ROE used in the calculation of residual
income?
A Residual income valuation can be calculated as the
sum of beginning equity and the present value of all
future periods’ residual income, which equals (ROE-
cost of equity)*beginning equity (of the period).
NB The reason we favor a residual income approach to
estimating intrinsic value is that it allows us to consider
the profitability drivers and all the basic accounts, as we
see in the profitability tree, where ROE is the fulcrum.

Dividend Payout Ratio and Dividend Yield
What’s Measured
• The dividend payout ratio is the percentage of net
income paid out as a dividend.
• The dividend yield is the cash dividend as a percentage
of the stock price.
Typical Use
• Dividend payout ratio is used to indicate the portion of
earnings returned to shareholders as a cash dividend. It can
also indicate the proportion of earnings reinvested, although
the return of capital ratio is better for this purpose.
• Dividend yield is considered a measure of a cash return
receivable by shareholders, as in general companies try not
to lower the dividends they pay. Changes in dividend
payout can also be important signals of future growth
opportunities.
• Dividend yield is sometimes compared with bond
yields to gauge relative pricing. The problem is that
dividends are only one form of return of capital.
ModelWare Approach
• To minimize measurement problems from using
different shares in the numerator and denominator,
especially for dividends per share and share price, we use
the total of common dividends divided by earnings for the
payout ratio and by market capitalization for dividend yield.
• To consider the potential issue of market capitalization
being distorted by accounting issues with diluted shares
outstanding, we also calculate a dividend yield (basic),
using the dividends per share (see page 53) and the current
share price.
Modelware– August 2, 2004
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Page 21
Underlying Economic Logic
Q What are the measurement issues with dividend
yield?
A There are several. The first concerns whether
companies elect to pay dividends on a per-share basis or
on the basis of absolute amounts. If it’s on a per-share
basis, the absolute amounts will vary with the shares
outstanding at the time the dividend is payable.
However, if companies consider dividends as part of the
capital they return, the dividends per share will vary
with the shares outstanding. In this case, there can
easily be a misalignment in the number of shares used
for dividends and share prices, creating a meaningless
calculation error. Even if this is not the case, a
company will reconsider its dividend paying policy
when there are substantial changes in the share count.
A Second, the timing of representing a dividend yield
creates the potential for misleading information.
Consider that share prices go down by the dividend
amount (potentially, tax-adjusted and for other
information effects) as this is a return of capital. So
immediately before the payment, the dividend yield is
lower than the day after the payment.
A Third, dividends are not the only form of return on
capital, and if a share repurchase is undertaken, share
prices also adjust, often upwards. So in this case, the
dividend yield is likely understated as a measure of
return of capital.
It is for this last reason that we also calculate a
repurchase yield and a return of capital yield.

Return of Capital Ratio and Yield (Gross and Net)
What’s Measured
• The return of capital in a period, regardless of its source,
as a percentage of net income for the ratio and as a
percentage of market capitalization for the yield.
Typical Use
• While we do not believe this is widely used, its main
use is to assess the proportion of earnings reinvested versus
that returned to owners (in aggregate) for the payout ratio.
• The return of capital yield is equivalent to the dividend
yield, although for share repurchases the “return” comes
from share price increases rather than a direct cash receipt.
ModelWare Approach
• The gross return of capital adds the amount spent on
share repurchases to the dividends paid. The net return of
capital starts with the gross return and deducts any capital
raised from share issuance for employee share and option
plans and the associated tax benefits.
• Each amount is divided by total earnings for the ratio
calculations and by the market capitalization for the yield
calculations.
Modelware– August 2, 2004
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Page 22
Underlying Economic Logic
Q Why are share repurchases considered a return
of capital like dividends?
A Companies choose to reinvest capital or return it to
shareholders. The payment back to shareholders can be
done directly as a dividend to all shareholders
outstanding (but excludes most option or contingent
equity holders) or indirectly by buying back shares.
This reduces the capital to reinvest but should raise the
stock price and thus deliver a “return” to shareholders,
even if they choose not to sell their own shares back to
the company.
Q Why are proceeds from share issuance related
to employee stock and purchase plans netted out?
A Many companies try to manage their shares
outstanding by buying back the same number of shares
exercised in a given year under an employee share or
option program. In such circumstances, including the
gross amount used for share repurchases would
overstate the true return of capital. We do not include
all share issuances as these are usually for additional
capital-raising purposes and have a different meaning.

Price/Book (P/B) and Price to Tangible Book Value
What’s Measured
• P/B is the ratio of the market value of common equity
to the recorded book value of equity, reflecting the premium
of market to book value.
• Price to tangible book value is calculated as above but
ignores any purchased intangible assets and premium on
acquisition.
Typical Use
• The P/B ratio is often used as a lower bound of value,
as a ratio of less than one would imply that the stock is less
than what the owners contributed. Realistically, this is
usually more relevant for tangible book value, as any
premium paid on acquisitions (goodwill) may have been
overvalued at the time.
• As with P/E or ROE, P/B is more appropriately used to
identify where the market is paying a premium (or not)
based on expectations of future growth.
ModelWare Approach
• To avoid the issues of share count differences,
especially when the price and book value are misaligned,
we calculate P/B as market capitalization relative to total
shareholders’ equity.
• To obtain tangible book value, we eliminate all
intangibles and goodwill, including the implied goodwill
calculated under ModelWare.
• For historical P/B, we use period-end measures, and if
we use the book value of equity per share, it would be based
on the period-end diluted shares outstanding, a number we
estimate.
Modelware– August 2, 2004
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Page 23
Underlying Economic Logic
Q What does a P/B above one indicate?
A Price deviates from book value of equity because
the market anticipates unrecognized future real growth,
and because most accounting systems have a
conservative bias that tends to understate the value of
the net assets.
Q What does a P/B below one mean?
A Again, there are at least two reasons. First, the
market believes that the company is going to destroy
value over time. Second, especially when goodwill is
included, the market can be signaling that it believes the
company overpaid for the intangibles or the acquisition.
Q What price should be used in historical and
future periods as book value changes?
A For historical periods, we use the price (market
capitalization) at the same time (end of the period) as
the book value of equity is recorded. As the current
price incorporates expectations about future events (and
could also reflect events that occurred after the relevant
period), we see no meaning in using current prices with
past book values.
A For forecast periods, we use the most current price.
Given that price is supposed to reflect expectations of
the future (on a present value basis), it seemed too
arbitrary to adjust prices without knowing what
information is already in the price.
NB As with P/E (page 13), there is an argument that
the analysts’ target price could be used for one year
ahead, or that the “future price” should be the current
price multiplied by 1+ cost of equity (per year),
adjusted for returns of capital. Without showing the
assumptions, rates, and calculations, however, neither
approach would support our objectives of transparency
and comparability. In addition, as expected shares
outstanding may change in the future (e.g., from share
repurchases), adjusting becomes even more arbitrary.
 Page 24

Morgan Stanley ModelWare Calculations:

An Overview

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Operating Revenue (OpR)
What’s Measured
• Value of sales (revenue) generated from ongoing
operating activity.
Typical Use
• Benchmark of activity and growth, usually the starting
point for forecasts.
• Consolidated revenue used to avoid double counting of
inter-company transactions, but can have little value for
conglomerates where segment data are preferred.
• Total revenue has limited value in forecasting without
knowing price/volume changes, FX impact, acquisition
activity.
ModelWare Approach
• Accept the basic local GAAP revenue recognition
principles, although we appreciate that the principles chosen
can distort (or be used to distort) the comparability of
reported revenue.
• Exclude sales or volume discounts, any excise or
similar value-added taxes, and standard allowance for bad
debts (where known).
• Include royalty and license income.
• Segment data will expand as ModelWare technology
evolves.
• For companies with financial services as operating
activity, classify fees and net interest income on the net
book (net operating assets) as operating revenue.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 25
Related Valuation/Performance Measures
Price/Sales, Operating Margins (PTOP, NOPAT),
Efficiency Ratios (OpATO)
Underlying Economic Logic
Q Should doubtful accounts or loan losses and
discounts be treated as expenses or reduction of
revenue?
A It’s too easy to inflate revenue if these items are
classified as expenses, so we show revenue net of
discounts and receivable/loan loss provisions unless
these are considered “one-time” or unusual.
This is not trivial, since revenue is the basis of
many margin calculations.
NB Generally we exclude one-time items, such as large
bad-debt write-offs, net of tax from both revenue and
operating expenses to simplify the calculation of taxes.
Q How does ModelWare treat operating revenue
from joint ventures and associated companies or
minority interests?
A We prefer proportional consolidation, but because
information is usually lacking, we default to exclude
this revenue.
NB Excluding minority share of operating revenue
would be the best adjustment, but this is not done as a
matter of course. Where feasible, we supply an
estimated percentage of minority investees’ “share” for
the metrics that clients need.

Operating Expense (OpE)
What’s Measured
• Costs incurred in ongoing operating activities, but
excluding the costs of funding those operating activities.
Typical Use
• Costs usually deducted from operating revenue to
calculate operating profit measures.
• Can also be used to assess improved cost control and
productivity in evaluating performance.
ModelWare Approach
• Data not available in most jurisdictions for ideal
presentation of cost components (cost of materials, labor,
capacity, research, services, marketing and distribution), so
we aggregate cost of goods sold, research and development,
selling, marketing and distribution, general and
administrative costs, and any other costs consumed in
operations. Where there is ambiguity about an item, we
consider it an operating expense.
• We do not break out cost of sales and services, because
consistency is lacking (e.g., in some companies and sectors,
depreciation is disclosed separately; in others it is included
in cost of sales, selling and distribution, and then G&A). So
ModelWare does not define a gross profit calculation that
can be considered comparable. However, some of our
analysts choose to use gross margin rates.
• We encourage analysts to link capacity investments and
cost of using capacity (depreciation), at least for changes to
steady-state reported numbers, though without more detail
we can’t link change in forecast capacity cost and expense
to a category like cost of sales on an income statement.
• As ModelWare evolves, we expect to supply increasing
amounts of segment data, but the segment level of operating
cost is usually inferred because ordinarily only segment
operating income is reported.
Modelware– August 2, 2004
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Page 26
Related Valuation/Performance Measures
Operating Margins (PTOP, NOPAT)
Underlying Economic Logic
Q How are nonrecurring costs treated?
A Eliminated at analysts’ discretion, though no
simple rule as to what is “recurring.” We focus on
forecast data, and good analysts tend to be consistent in
excluding historical items from forecast costs, margins,
etc.
Q What about asset write-offs?
A Impairment charges of depreciable assets are a sign
of past underdepreciation and are often
(inappropriately) treated as non-recurring or one-time
charges. Regular charges for inventory obsolescence,
frequent adjustments in workforces, and gains/losses on
sale of operating assets in most cases are just part of
business and so should not be treated as one-time costs
but left as ongoing operating expenses.
NB Our analysts decide whether an item is recurring or
not, but we expect the increased transparency to
highlight the frequency and so reduce the incidence of
treating recurring costs as if they are non-recurring.
Q Is LIFO or FIFO preferred for inventory
costing?
A We choose FIFO for comparability and simplicity.
Replacement cost is the best measure of ongoing cost,
and LIFO is closest to this, especially in times of rapid
price change. We lack the data to transform FIFO into
LIFO, however. And if the IASB moves to FIFO, as
we expect, the LIFO data should be scarcer.
NB We keep the LIFO data so users can add to COGS.
This is most useful where there are structural price
changes over a number of periods.
LIFO usually distorts balance sheet measures of
inventory more than the use of FIFO distorts income;
via a LIFO reserve, this method also creates the
opportunity for earnings manipulation.
continued
 Page 27

Operating Expense (OpE) (continued)

Related Valuation/Performance Measures

Operating Margins (PTOP, NOPAT)

Underlying Economic Logic

Q How is goodwill amortization handled?
A We exclude goodwill amortization and amortization of intangible assets assumed to have an “indefinite” life; we add
back these charges to operating assets. Such amortization is double-counting costs if a firm is sustaining its franchise. If it
is not, then we would expect an impairment charge. New International Financial Reporting Standards and current US
GAAP treat it this way.
NB Where information is available to indicate that the intangible is tax-deductible, we tax-effect this adjustment;
otherwise, we assume it is tax-free.

Q How is acquired in-process R&D treated?

A Non-recurring or one-time acquired R&D is deemed part of an acquisition premium and not expensed but treated as
part of goodwill. The recurring portion is equivalent to outsourced R&D and expensed.
NB If acquired R&D relates to specific products, it should be treated as acquired products, not R&D.

Q Does ModelWare capitalize R&D and amortize it over some period?

A No, on a global cross-sector basis, it’s too arbitrary. There are some valid arguments for R&D capitalization, but
adjustments are too subjective (limited detail on underlying products in research, shrinking payback periods for R&D
investments, arbitrary amortization periods).
NB For early stage, rapidly growing companies, the impact on earnings is large, but for all others the earnings impact is
usually small, so capitalizing merely bumps up invested capital. Such adjustments have no bearing on appropriately
specified multi-period valuations, like DCF or residual income valuation.
Q What about pension costs and other post-employment benefits (like retirement health benefits)?
A We eliminate interest costs on pension obligations, returns on pension (trust) assets and actuarial adjustments from
OpE when material, since these are more appropriately treated as non-operating or funding items.

NB In the US and certain other jurisdictions, these items are incorporated in operating costs. The change will generally
cause companies with underfunded net retirement obligations to lower their costs, and those in surplus (or close to it) to
increase their operating costs.
Without this adjustment, it is trivial for companies to create operating income from financing costs by borrowing and
then investing the cash raised into the pension. This confuses asset management returns with normal operating activity.

Q How does ModelWare handle non-cancelable operating leases?

A The choice to lease property or equipment is a financing decision, so where operating leased assets are significant, we
would capitalize and treat them as if purchased at lease inception.
A Given limited data, we don’t insist on adjustments in all cases. But for transparency and comparability, where material
operating leases distort comparisons, our global sector leaders decide whether to capitalize. Our retail and transportation
teams make the adjustment today; we anticipate that more teams will do likewise, especially as clients get more
comfortable with the adjustment.
continued

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.
 Page 28

Operating Expense (OpE) (continued)

Related Valuation/Performance Measures

Operating Margins (PTOP, NOPAT)

Underlying Economic Logic

NB Capitalizing operating leases reverses the lease (rental) charge and includes a depreciation charge in operating expense
and interest charge in financing expense through the life of a lease. Operating expenses tend to fall, but interest costs rise,
so net income is lower, in growth phases and a lease’s early stages. This reverses at the end of any given lease.
Global accounting rules allow some leases to be classified as “operating,” forcing the lease payment to be treated as
an operating expense, distorting comparisons for companies with differing buy vs. lease patterns. We expect accounting
regulators to address this issue before long.
Q Are options and other share-based compensation expensed?
A We expect to include all such payments to employees as operating expenses by year-end 2004, assuming new US
regulations are in force in 2005, as they are for countries using International Financial Reporting Standards. To date this
has been at the discretion of the analyst. We don’t require this adjustment yet because we expect that required expensing
will dramatically reduce the size of option grants, so historical measures will not be a good guide of future charges.
NB We make specific adjustments in some regions. For example, in Taiwan, companies issue shares to employees at par
value, but only approve them after the year in which they are earned. We add them to labor costs at market value in the
year in which the services are performed.
The cost of labor is distorted in various countries by the use of share-based payments that are not recognized as costs
or expenses. Share prices may not reflect these costs as equivalent to cash compensation, but we see no other way for
meaningful global comparisons of operating expenses, as zero cost for these grants is clearly incorrect.

Q Are all taxes treated similarly?

A Regions and states tax companies in many different ways, so we try to isolate the source of tax and reflect it
appropriately, although data are limited. When a tax is production-specific, we treat it as an operating expense, as in the
energy sector, where the production or “lifting” of oil and gas can trigger a tax. As discussed above, we net any excise or
sales taxes from operating revenue, where the company serving as a collection agency.
A For items identified as “one-time” and excluded from “operating expense,” our analysts have reflected these net of tax
so that we can more appropriately capture the tax on other items.

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Pre-Tax Operating Profit (PTOP)
What’s Measured
• Pretax profits from operating activities. Equivalent to
EBIT (Earnings Before Interest and [Income] Tax) in
countries without goodwill amortization, or EBITA for
those that still amortize goodwill on acquisition.
Typical Use
• A key measure of operating profitability often used in
calculating operating margins, when considered before
taxes.
ModelWare Approach
• Our basic approach includes all revenue and expenses
that relate to operating activity, but we also adjust for
certain items like unconsolidated associate company income
when there is no proportional consolidation and the
associated companies are integrally linked to the operations
of the investor company.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 29
Related Valuation/Performance Measures
PTOP (Operating) Margin
Underlying Economic Logic
Q Is proportional consolidation used for associated
companies?
A For associated companies with operations
integrally related to the parent’s, we classify the
“equity” income as “operating” and include in PTOP.
For others, where the operations are run independently,
we classify the income “non-operating.”
NB Most global accounting rules do not allow for
proportional consolidation, but include equity income
from investees in which the investor has significant
influence (usually presumed when the holding is ≥ 20%
of shares outstanding) in operating profit. These
investees are labeled associate companies.
Q How does ModelWare regard dividends from
investments not treated as associate companies?
A Analysts may want to classify certain large cross-
holdings or strategic investments as operating in nature
and even adjust them to a market value to capture the
underlying returns they generate. These are usually
non-operating in nature, but they may be classified in
operating, too, if appropriate.
Q How do discontinued operations affect PTOP?
A We adjust PTOP for dispositions or discontinued
operations and in rare cases acquisitions as well, where
these are not already included in the PTOP.
continued
 Page 30

Pre-Tax Operating Profit (PTOP) (continued)

Related Valuation/Performance Measures

PTOP (Operating) Margin

Underlying Economic Logic

Q Do financial services companies have operating revenues and expenses…and PTOP?
A After some debate, we concluded that the firm’s operating activity is the key. Interest or fees on loans and leases
might be financing in a traditional industrial company — but operating in a financial services company. Although the logic
and calculations are similar, the specific items included will differ.
A In the case of finance companies that are integrated with commercial and industrial operations and that have financing
customers of the operating business as their primary activity, we consider these activities operating, too. As ModelWare’s
technology evolves, we plan to increase segment data so that these activities can be considered by type of business.

NB With many such “captive” finance companies, there is no meaningful way to isolate the financing activity both in fact
and given disclosures. It is easy for companies to cross-subsidize their industrial operations to reflect a “desired” but
unsustainable operating margin through financial subsidies. The ModelWare treatment thus provides greater comparability
of the joint activities, and in these cases looking at either activity alone is likely to be distorted, we believe. For example,
our global auto team has taken the position that the finance companies are “extended marketing arms” of the auto sales and
manufacturing businesses.

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Net Operating Profit After Tax (NOPAT)
What’s Measured
• The after-tax profits from operating activities.
Typical Use
• A key measure of operating profitability often used in
calculating operating margins, when considered after taxes.
ModelWare Approach
• We eliminate taxes from pretax operating profit by
applying a “statutory” tax rate (inclusive of federal, state
and local taxes) to the taxable components of PTOP.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 31
Related Valuation/Performance Measures
NOPAT (Operating) Margin
Underlying Economic Logic
Q Does ModelWare normalize taxes for
comparability?
A Our analysts consider the annual statutory tax rate
that a company would be expected to pay, weighted for
the share of operations in each region in which it
operates. A true measure of sustainable operating
performance requires an after tax measure, which many
corporations and investors use.
A This statutory rate is applied to PTOP (less known
non-taxable components). The statutory rate changes as
the mix of regions or regional rates change.
A We also use the statutory rate for financial
income/expense. The “true-up” reconciliation between
operating and financing computed taxes and reported or
estimated tax expense is included in other non-
operating items.
NB A company’s reported tax expense includes a
complex combination of cash, accrued and deferred
taxes on operating, financing and other non-operating
items, including items that never flow through earnings.
Deficiencies in current disclosures limit one’s ability to
clearly separate these components.

Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA)
What’s Measured
• A measure of pretax operating income before charges
for cost of capacity, intangibles and goodwill. It is not a
measure of operating cash flow in any way.
Typical Use
• A “quick and dirty” measure from the LBO era to get to
the short-term ability of a company’s operations to generate
cash.
• In times of heavy capital spending, it began to be used
(incorrectly) as a measure of sustainable operating cash
flow. We believe that this is a significant error and that this
measure has no conceptual or practical validity, especially
in capital-intensive businesses. Although the ModelWare
calculations’ developers would prefer to exclude it, at the
request of some analysts and clients, we provide it.
• In fixed income analysis, Debt/EBITDA is used as a
multiple to reflect how quickly the operations can fund the
outstanding obligations. We view this as particularly
inappropriate, given that debtholders are most concerned
with real cash flow and liquidity.
ModelWare Approach
• We basically add back depreciation and amortization
charges to our measure of PTOP.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 32
Related Valuation/Performance Measures
Enterprise Value (EV)/EBITDA, EBITDA Margin
Underlying Economic Logic
Q Is the ModelWare version of EBITDA different
from others?
A Yes, because we exclude returns on pension assets
and interest on pension obligations and capitalize
operating leases, effectively removing any charge for
the related assets. Economically, choices about pension
funding are financing and show asset management
skills, not operating skills. If pensions are unfunded,
EBITDA will rise as the interest cost is eliminated;
where pensions are funded, it could go the other way.
Q How are partial ownership, consolidated
minority interests, or equity-accounted associate
companies or JVs treated?
A As in PTOP, if the associate company is considered
operating in nature, then the equity income is treated as
operating and included in EBITDA.
A As equity income is the investors’ share of net
income, we have provided within ModelWare a set of
measures that allow the analysts to create a version of
EBITDA as if consolidated. Analogously, they can
remove a minority share in an equivalent manner.
NB Our telecom team has chosen to provide a majority
calculation for EBITDA in which they identify the
percentage of consolidated EBITDA that relates to a
minority stake. This is most applicable to the joint
ventures that are found in the wireless operations.
 Page 33

Earnings Before Interest, Depreciation, and Amortization (EBIDA)

What’s Measured Underlying Economic Logic

• An after tax measure of EBITDA.
Typical Use
• This measure suffers the same negatives as EBITDA,
because it is just the after-tax equivalent, and we see no
valid use for it.
Q What tax rate is used in calculating EBIDA?
A EBIDA has the problems of EBITDA compounded
by the difficulty in measuring the tax impacts. We use
the statutory rate for the same reasons that we use it in
deriving NOPAT from PTOP.

ModelWare Approach
• As with NOPAT, we recognize any non-taxable
elements of D and A, where known.

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Net Financial Income/(Expense) (NFE)
What’s Measured
• Cost or income from assets or obligations designated as
financing, typically activities under the jurisdiction of senior
financial officers such as treasurer, CFO, finance director.
Typical Use
• Net financial expenses are usually considered both the
cost of servicing the non-equity financing of operations, and
costs to be covered before equity holders get any return on
their investment.
• A key component in understanding the benefits of
effective capital structure decisions.
• When there is net financial income, the measure shows
how the company is managing surplus financial
assets/investments and is also a measure of financial safety
or opportunity for new investments.
ModelWare Approach
• We isolated those items considered financing in nature
to avoid potential distortions from including income and
costs of all non-operating items as financing.
• We net the cost of financing obligations and the income
on financing assets. The net reflects financing strategies by
companies, for example, with both large obligations and
cash and marketable securities. This mix is usually a
conscious decision about funding operations and growth, in
light of strategic choices for capital raising (or return of
capital to shareholders).
• There are problems with classifying some amount of
“cash” as operating, so we treat all financial assets/liabilities
and the related income and expense as financing. A cash
position is just a form of financing flexibility; some
companies manage “operating cash” via a bank overdraft;
for others, a bank line of credit or short-term borrowing
facility is considered part of the short-term financing mix.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 34
Related Valuation/Performance Measures
Return from Financial Leverage
Underlying Economic Logic
Q What are the most common components of
NFE?
A Traditional interest and dividend income on
financial investments, and interest expense on financial
obligations. We include preferred dividends as we
consider preferred stock a financial obligation.
Q How are foreign currency transaction
gains/losses treated?
A We include FX transaction gains and losses
reported in earnings as part of NFE, even if these result
from exposure of trade receivables and trade payables,
as the decision to carry these is a financing decision.
NB For now, we exclude gains/losses from foreign
currency translation adjustments (included in other
comprehensive income or statement of total recognized
gains and losses), even though these are financing costs
and often result from loans deemed part of net invested
capital. Companies do not provide enough information
to facilitate meaningful forecasts, and historical
translation adjustments are not split between debt and
equity financing. We have seen no client demand for
this to be included in earnings.
Q What about monetary gains/losses from
application of inflation accounting?
A We treat gains/losses on net monetary items
resulting from price-level adjustments as financing
costs. These reflect an offset to the inflationary effect
of monetary items that are reflected in the interest rates
applied, when inflation plays a large role.
continued
 Page 35

Net Financial Income/(Expense) (NFE) (continued)

Related Valuation/Performance Measures

Return from Financial Leverage

Underlying Economic Logic

Q What other financing costs are included in NFE?
A We include gains or losses on extinguishment of debt, as early recognition of future costs.
A As discussed above, we also include imputed interest cost on capitalized leases, and the interest cost on all post-
employment obligations (pensions and OPEBs), the expected return on related (pension) plan assets, as well as the net
actuarial gain or loss recognized.
A We include the expected return on pension assets and not the actual return (for now) as the pension funds’ asset
allocations would differ if the accounting changed. We acknowledge that companies can be unrealistic in the expected
return they use, but without detailed knowledge of asset allocations (details now beginning to be disclosed) it is impossible
to judge the appropriate rate fairly. We do reflect the economic surplus or deficit in net debt, and the amortization of
unrecognized amounts is included in earnings.
A As discussed above, we apply the statutory tax rate to the net financing income (expense).

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Other Income (Expense)
What’s Measured
• Additional items included in net income or earnings not
designated as operating or financing.
Typical Use
• This customarily ignored item, which contains non-
operating items and the “clean-up” of the tax expense,
should raise questions if it is large.
ModelWare Approach
• Rather than include all non-operating items together,
we split this out in order to show the financing aspects of
the business on their own and to facilitate analysis of capital
structure and funding analysis.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 36
Underlying Economic Logic
Q What items fall under Other Income (Expense)
A Equity income, or the change in unrealized
“revaluation” gains and losses in investments classified
as non-operating.
A Minority interest in net income (but excluded
when analysts can do proportional consolidation). It is
generally impossible to know the minority share of
components of operating revenue, operating expense
and NFE, so we have to treat this as a composite
amount.
A Other pension income or expense items, such as
curtailments or amortization on transition assets, as
required under US GAAP.
A Any other items that are clearly neither operating
nor financing.
A A tax adjustment to reflect difference between
“reported” tax expense and the sum of other tax items
taken into account with the use of the statutory rate (see
above).
NB In order to avoid classifying taxes relating to one-
time items excluded from our measure of net income,
our analysts tag these items net of taxes. The tax
expense used here excludes these.

ModelWare Net Income (a.k.a. ModelWare Earnings)
What’s Measured
• The wealth creation (or loss) from all a firm’s activities,
excluding items considered one-time or non-recurring.
Typical Use
• Most investors want a single summary measure of a
firm’s performance that they can “capitalize” as an annuity
stream. Analysts or investors often seek an “adjusted,”
“core” or “normalized” earnings measure to do this, but
these terms are quite ambiguous, and it is not possible to get
a measure that captures the full meaning of these terms.
ModelWare earnings are often close to what our analysts
were doing in getting to these measures.
ModelWare Approach
• We use a net income measure that sums NOPAT, NFE
and Other Income (Expense).
• No single measure can reflect the complexity of a typical
company. But as many investors still want one, in this
measure we exclude items that are unlikely to persist, as
well as other items whose future changes are not
measurable with current disclosures.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 37
Related Valuation/Performance Measures
Price to Earnings (P/E), Return on Equity (ROE)
Underlying Economic Logic
Q Should one-time items be included?
A We encourage analysts to presume items are
recurring unless known to be otherwise. In forecasts,
items that are not expected to recur or are almost
impossible to forecast and are inevitably excluded, so we
choose to exclude these in historical analysis, too.
NB Non-recurring items usually do affect value, but with
a low valuation “multiple.”
Q What about items that accounting rules include
as “other comprehensive income” (or equivalents)?
A We leave foreign currency translation adjustments
out of earnings (see discussion under NFE), because
disclosure is inadequate for meaningful forecasts. But
for financial services firms that are actively trading, the
distinction between unrealized gains and losses on mark-
to-market of investments categorized as “trading” versus
“available for sale” is somewhat arbitrary. Both are
marked to market, but for trading, the unrealized gains
and losses are recognized in earnings, while those
available for sale are recognized in comprehensive
income. To enhance comparability and better reflect
economic reality, we include unrealized gains and losses
on available-for-sale securities in ModelWare earnings
for financial services firms, unless the analyst deems
them to be one-time in nature. Realistically, most
analysts currently would not incorporate unexpected one-
time gains or losses in their primary forecasts.
continued
 Page 38

ModelWare Net Income (a.k.a. ModelWare Earnings) (continued)

Related Valuation/Performance Measures

Price to Earnings (P/E), Return on Equity (ROE)

Underlying Economic Logic

Q Is there a way to see earnings without the ModelWare adjustments?
A One of the powers of ModelWare is that you can create your own measures with your own labels. We originally
considered showing earnings before ModelWare adjustments, but the label was too opaque as to what was “adjusted,” so
we scrapped it. Instead, we provide earnings before operating lease adjustments, because this is the one adjustment that
will create the largest contrast to what most people are used to seeing.
A We also provide net income (reported) so that clients can have an anchor to use.
A In some countries, notably Japan, or sectors, there are other earnings measures with standard labels. We supply these,
too, but indicate that they are region- or sector-specific. For example, Recurring Profit (Japan) is essentially net income
before company-defined extraordinary items and before tax.

Q What about “core” or “normalized” earnings?

A We have chosen not to use these terms, which we consider ambiguous and thus contradictory to our objective of
transparency. Standard and Poor’s has a standardized measure it labels “core earnings,” but we disagree with its approach
and so have not provided this measure.

Modelware– August 2, 2004

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Net Income (Reported) (a.k.a. Earnings [Reported])
What’s Measured
• Earnings based on the accounting rules a company uses
in its own reports.
Typical Use
• We expect this will be used by clients who are not
interested in comparative measures and those who want to
reconcile our measures with a company’s reported earnings.
Modelware– August 2, 2004
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Page 39
ModelWare Approach
• We eliminate the adjustments incorporated into
ModelWare Earnings, including one-time items, operating
lease adjustments, and others to get back to the measure that
is equivalent to what a company would be expected to
report.
• We do not try to reflect a measure that a company
might call “pro forma,” as the spirit of such a label is what
we are trying to capture in ModelWare earnings themselves.

Diluted Earnings per Share (EPS)
What’s Measured
• The earnings attributable to a single share of the
company, assuming dilution of contingent shares (e.g.,
convertibles and employee stock options).
Typical Use
• Diluted EPS is the main measure used to calculate
price-to-earnings ratios.
ModelWare Approach
• We adjust net income for the net income attributable to
convertible securities (such as convertible debt or preferred
stock) and then divide the result by the analyst’s measure of
average diluted shares outstanding.
• In general, the measure of diluted shares outstanding
mirrors that defined under current accounting regulations.
• We perform the equivalent calculation for alternative
measures of earnings, such as reported earnings.
Modelware– August 2, 2004
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Page 40
Related Valuation/Performance Measures
P/E (Diluted)
Underlying Economic Logic
Q Why use diluted shares outstanding, and why
use the average rather than period-end shares?
A Stock prices are presumed to factor in expected
dilution, and so therefore should the denominator in P/E
calculations. Among the various ways to calculate the
impact of dilution, we follow the basis used by each
company. Because earnings are measured over a
period, a period-end measure would not be consistent.
Share issuance or repurchase also changes the net asset
position during a period and hence the related earnings.
NB Under most current accounting rules, convertible
bonds and preference shares with out-of-the-money
conversion rights are still treated as if converted, yet this
does not reflect the economic dilution and so
presumably would not be priced in. We plan to develop
a more economically valid measure of diluted shares
outstanding; for now, we also provide all measures
using basic shares outstanding and label them
accordingly.
NB Even a weighted average does not produce a perfect
picture of earnings attributable to an actual share
outstanding. The potential exercise of contingent shares
assumed to be in the money complicates the forecast of
diluted shares outstanding.
Another problematic issue concerns the presumed
repurchase of shares based on proceeds of issuance of
warrants, employee stock options, and their equivalent.
Current accounting rules presume such repurchases will
occur by applying what is known as the “treasury stock
method,” but the actual repurchase is at a company’s
discretion. The company’s choice of whether and when
to repurchase will determine the forecast diluted share
count and future earnings (in different proportions,
depending on the expected rate of return on related
funds).
continued
 Page 41

Diluted Earnings per Share (EPS) (continued)

Related Valuation/Performance Measures

P/E (Diluted)

Underlying Economic Logic

Q What happens when there is more than one type of equity share?
A There are many idiosyncrasies when shares carry different participation percentages, for example, or trade on different
exchanges. We consider the portion of earnings that is distributable to each share class in making a specific EPS
calculation.
NB This issue is more problematic when calculating market capitalization, which we discuss separately.

Q What about the reported or before-ModelWare measures of earnings?

A Each measure of earnings will be labeled appropriately, and EPS will be calculated using both diluted and basic
average shares outstanding.

Modelware– August 2, 2004

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 Page 42

Basic Earnings per Share

What’s Measured Related Valuation/Performance Measures

P/E (Basic)
• Earnings attributable only to shares actually issued
during the period.
Underlying Economic Logic
Typical Use
See comments above
• Used to consider EPS for a shareholder today. This
measure should be interpreted cautiously when used in
calculations that also use price, e.g., P/E.

ModelWare Approach
• Net income divided by average basic shares
outstanding, where basic represents the shares actually
issued and trading in the period.

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Free Cash Flow to Equity Holders for Cash Flow Yield (FCFfY)
What’s Measured
Free cash flow equivalent of net income that reflects an
estimate of free cash flow earned in a period for equity
shareholders.
Typical Use
• Some investors regard cash flow as a “clean” measure
of performance, believing this fosters comparability and
eliminates accounting problems. This is unfortunately not
the case, but cash flow is still used as a substitute for
earnings, as price to free cash flow (similar to P/E) or cash
flow yield ratios (similar to E/P).
• FCFfY is not a measure of liquidity or of cash flow
from operating activities alone. It is free cash flow from the
business in the current period that is attributable to equity
shareholders, analogous to a measure of earnings.
ModelWare Approach
• We seek to capture cash flow equivalent measures that
relate to operating activity, (net) debt service, and other
income or expense items.
• We exclude changes in debt principal and new equity
financing.
• We include a portion of capital expenditures that are
considered to be investments in operations for future growth
(“growth capex”), but exclude spending on capacity to
sustain current levels of revenue (“required capex”).
• Given the opacity in attributing taxes to different
activities and in linking accruals in earnings (e.g., in
operating revenues and expenses) with the related balance
sheet accounts (like receivables and provisions), we
presume that forecast changes in the balance sheet accounts
are sources or uses of cash and then adjust the related
forecast earnings for potential non-cash items.
• For historical data, however, we rely on the actual
measures provided by companies, because of the impact of
foreign currency translation and acquisition-related
activities on balance sheet changes without real cash flows,
as well as company adjustments for non-cash items.
Modelware– August 2, 2004
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Page 43
Related Valuation/Performance Measures
Price to Free Cash Flow, Free Cash Flow Yield
Underlying Economic Logic
Q What is the appropriate starting point to
measure FCFfY, and what adjustments are
necessary?
A We start with PTOP, not EBITDA. We adjust for
all known items that did not have a direct cash flow and
were not “covered” by changes in balance sheet
accounts, such as cumulative effects from changes in
accounting principle or unrealized gains/losses on
operating investments. We add back depreciation but
then charge for “required” capital expenditure, the
spending required to maintain current revenue.
There are many pitfalls in the usual approach to
get a measure of free cash flow from operations:
starting with EBITDA (usually excluding one-time
items), adjusting for changes in working capital
accounts (and sometimes items considered “non-cash”),
subtracting capital expenditure, using an assumed
effective tax rate on the net amount, and assuming the
tax-adjusted interest expense was the debt service.
Changes in working capital also create problems with
such calculations: They can include items not included
in EBITDA (like one-time items); they often include all
tax accounts in the balance sheet, despite the fact that
there are financing and investing taxable components in
the tax payable and receivable accounts; and they are
directly affected by acquisitions (see below). Pension
costs in traditional measures of EBITDA are a
composite of service (operating) costs and funding
costs, and the final cash flow is the contributions made
to the pension fund or benefits paid by the company
(versus the fund). Minority interests and equity income
from associate companies also obscure comparability.
NB We have chosen not to define working capital;
given the disparate operating cycles of different
businesses, we cannot find a logic to its use in
comparative analysis, and its loose definition makes it a
poor candidate for liquidity analysis.
continued
 Page 44

Free Cash Flow to Equity Holders for Cash Flow Yield (FCFfY) (continued)
Related Valuation/Performance Measures
Price to Free Cash Flow, Free Cash Flow Yield

Underlying Economic Logic

Q What about acquisitions and disposition of assets or businesses?
A We use changes in various balance sheet accounts to calculate forecast free cash flows, so we have an item for net
amounts from acquisitions/dispositions to ensure we capture the cash spent.
NB In reality it is virtually impossible to reflect the true cash consequences without knowing all the details of what goes
into each account from an acquisition, but for forecasts this is not a major issue. In historical data, we assume companies
correctly strip out acquisition-related items from the change in balance sheet accounts used in the cash flow statement.
Q Taxes are notoriously difficult to incorporate into cash flow measures: what does ModelWare do, especially
when debt-related cash flows and equity funding are split from free cash flow to calculate free cash flow yield?
A We isolate cash tax issues related to debt or equity funding — including the tax benefit from deductibility of the
exercise of employee stock options — then include all other tax adjustments in free cash flow, for purposes of cash flow
yield. Such an approximation is unavoidable with no disclosure of the items necessary to estimate potential cash taxes to
be paid.
NB It is difficult to reconcile all the cash flow categories to actual taxes paid historically, a disclosure many jurisdictions
require. Similarly, it is not always possible to know whether the tax benefit on exercise of ESOs is in taxes payable, or
whether there are deferred tax assets associated with any expensing of ESOs or other, similar items. We isolate these
items when we can.
Without the ability to clearly separate taxes, we are reluctant to describe free cash flow from operations apart from
debt service. For users who want this despite the difficulty, we assume that debt service is taxed at the statutory rate and
then encourage analysts to attempt to separate deferred tax assets (liabilities) into operating and financing components.
Q Are one-time items eliminated in the measure of free cash flow?
A We attempt to exclude one-time items in our estimates of free cash flow for cash flow yield purposes. However, it is
necessary to isolate the actual cash used or received. In the absence of specific information to the contrary, one-time items
need to be included as they frequently generate receivables, payables or adjustments to other accounts. Given the
inclusion of such changes in balance sheets, not adding back the one-time items to PTOP would create a false measure. In
historical cash flows, we allow for this elimination, and would do the same for forecasts, in principle, but we cannot know
the actual timing of any cash flows related to these items or in which accounts any related accruals are found. The tax
treatment of these items (level and timing of tax payments) exacerbates the difficulty.
NB We accept that this can make free cash flow yield measures more volatile, but the alternative of assuming that all these
items are non-cash will generally overstate the free cash flow yield. Further, if there is a real distortion we would expect
that a series of new queries by the analyst would help to identify the real cash flows.
Q What are the real cash flows related to pensions and other post-employment benefits?
A We treat the service costs as an operating use of cash, because the current or incremental prior service cost is
compensation, with the cash payment borrowed (deferred) from the employees. If the company were to fund this
immediately and invest in an insured annuity, there would be no other cash flow. If the funds are truly “borrowed” and a
mismatch between pension assets and the obligations creates periodic funding needs, this is considered financing. So if a
company does no funding in a year, the net will balance out to zero.
NB The portion of the pension costs that go into NFE we treat as debt service; any net balance contributed or paid out as
benefits in excess of the recognized operating and financing components is treated as a change in debt principal. Reported
cash flow statements are much less clear about cash flows related to pensions.

Modelware– August 2, 2004

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 Page 45

Free Cash Flow per Share Diluted

What’s Measured
• The free cash flow to equity holders for free cash flow
Related Valuation/Performance Measures
Price to Free Cash Flow, Free Cash Flow Yield
yield, attributable to a single share of the company,
assuming dilution of contingent shares (e.g., convertibles
and employee stock options) Underlying Economic Logic
Q Does free cash flow per share reflect the cash a
Typical Use
shareholder has earned during the period?
• Used to calculate a measure of price to free cash flow A The notion that the cash of the firm is the cash of
or cash flow yield; analysts and investors are increasingly the shareholder can be quite misleading. More
interested in using such a relative value measure. realistically it is a cash equivalent of the EPS that the
firm has generated from its business during the period
ModelWare Approach but not distributed to shareholders.
• We use our measure of FCFfY and divide it by the
analysts’ measure of average diluted shares outstanding.
• In general, the measure of diluted shares outstanding
mirrors that defined under current accounting regulations.
As with EPS calculations, we also supply a Free Cash Flow
per Share Basic calculation, using basic instead of diluted
shares outstanding in the denominator.

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Free Cash Flow to Equity Holders for DCF (FCFDCF)
What’s Measured
• The free cash flow that would be used to calculate a
DCF at the equity holders (rather than “entity”) level.
Typical Use
• Used in DCF calculations if done at the shareholder
level.
ModelWare Approach
• We take the FCF for yield purposes and then deduct the
cash flow related to one-time items, growth capex, and cash
from acquisitions and disposals, and then adjust for
principal changes in net debt. Thus, this measure shows the
net cash flow for the period excluding cash flow related to
equity financing.
Modelware– August 2, 2004
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Page 46
Underlying Economic Logic
Q Why not calculate a FCF for DCF at the entity
level?
A First, separating operating from financing cash
flows is highly problematic given lack of disclosure
concerning the relevant tax cash flows, and given
ambiguity in distinguishing some payables from
receivables. Second, we have found that in practice, the
weighted average cost of capital is difficult to calculate
accurately, especially as it changes over time. The
main problem is that we lack adequate measures of the
market value of debt measures and how the free cash is
deployed over time, both of which would change the
weighting and expected return measures.

Net Operating Assets (NOA)
What’s Measured
• A firm’s net resources needed to run the operations of
the business and generate the operating revenue. It does not
consider the specific source of external funding.
• This is analogous to the invested capital that the
company is using to run its basic business.
Typical Use
• NOA is used to assess operating efficiency.
ModelWare Approach
• ModelWare looks to the assets (resources) and
liabilities (obligations) that are actively managed in
generating operating revenues and expenses. This is often
most easily achieved by identifying what is strictly
financing and what is clearly non-operating in nature. If
there is doubt, we usually assume that the asset or liability
is operating.
• Where material, ModelWare operating assets include
any unrecognized premium from past mergers and
acquisitions, either from transactions treated as pooling (or
uniting) of interests, or from previously amortized or
written off goodwill. The analyst can recognize an amount
as being impaired if this asset has been written down or
should be.
• ModelWare net operating assets include the remaining
implied book value of capitalized non-cancelable operating
leases, but exclude any pension surplus or deficit, which is
treated as financing.
• ModelWare NOA include the investments in associated
companies that are integrally related to the other operating
activities of the firm.
• We do not try to distinguish working capital items or
determine if they are current or non-current, as we found
these concepts impossible to operationalize in a consistent
and economically meaningful way.
Modelware– August 2, 2004
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Page 47
Related Valuation/Performance Measures
RNOA, OpATO
Underlying Economic Logic
Q Why is all goodwill added back and added to net
operating assets?
A Net operating assets represent the capital invested
in performing the operating activity of the firm. In any
acquisition (or merger), the purchase price reflects the
acquisition of net assets, and if there is a premium paid,
it applies to future operating profitability. As any such
profitability is already “paid for,” there is no value
creation when it occurs. In order to understand
whether the merged entity is incrementally profitable,
it is necessary to consider the full amount of capital
invested.
NB The main advantage of capitalizing all goodwill is
to better understand how profitably managers have
invested shareholders’ funds, and to observe whether
these returns exceed the required return — not in a
single year but over time. This distinction is important
because initially, profitability will be lower and often
below the cost of capital, as the cumulative amount of
purchased future profitability is recognized
immediately.
Q Why are non-cancelable leases capitalized and
added to operating assets?
A Net operating assets reflect the operating resources
(capital) used in a business. Leasing is simply a choice
of how to finance assets used in operating activity. So
it is impossible to make a meaningful judgment about
how efficiently or profitably the company is operating
relative to competitors — or even relative to prior
periods — unless all operating resources are included.
NB Capitalizing leases can provide unique insights into
the relative performance of certain companies (see our
1998 Apples-to-Apples sector reports on airlines and
pan-European retailing). In expanding the exercise to
our global coverage of transportation and retail with
ModelWare, we again learned how certain companies
had changed and were less efficient and more
leveraged than it appeared before these adjustments
were made.
continued
 Page 48

Net Operating Assets (NOA) (continued)

Related Valuation/Performance Measures
RNOA, OpATO

Underlying Economic Logic

Q Why aren’t pension assets and obligations operating items if they arise from deferred compensation of
employees?
A The key reason is that companies can choose to pay for the deferred compensation immediately and invest in an
insured annuity product to insure the payments that need to be made. This is generally not done, because companies view
this as “too expensive,” and they want to keep the cash or invest and manage the investments if there is a pension fund.
Thus, the choice they are making is a financing one.
NB Accounting regulators have begun to reconsider the current classification; the UK Accounting Standards Board has
made this change already. We believe that accounting standards globally will converge to this treatment over time.
Q Why isn’t there any cash in operating assets?
A There is no meaningful way to identify what cash is “needed” to operate a business. In addition, in many countries,
operating cash is actually a “bank overdraft” or line of credit which many people view as clearly “debt” or financing. Cash
management is also an activity generally undertaken by the treasurer’s office, and under our criteria, this is financing.
NB In financial services companies, the managed investments and “cash” balances, deposits, loans, and leases are treated
as operating assets or liabilities.
Q If cash is financing, does this mean that securitized receivables or other assets are no longer in operating assets?
A No. If operating assets are securitized but remain “managed” or used by the company, ModelWare reverses the
securitized assets and puts them back “on the books,” as if they were collateralized borrowing. We have a tagged item for
this category that is added back to net operating assets and financing.
NB In reality, disclosures do not always provide enough information to correctly add back such securitized items, and
many analysts have not tracked this information.
Q What has happened to LIFO reserves?
A In times of changing prices, while the replacement cost of inventory is generally the most appropriate economic
measure, these data are not available. The difference between FIFO and LIFO inventory is usually disclosed, so we add
back this reserve to the inventory, and hence it is part of NOA. As in our discussion of operating expense (page 26), this is
not just driven by our comparability objective but also because the distortion to inventory values is cumulative and
generally higher than any single year’s adjustment to earnings.
Q How are asset revaluations dealt with?
A In some countries it is possible to revalue physical assets (usually PP&E) on a regular basis. Economically, this is
often a better answer, but it is not available generally. At first, from a comparability perspective, we might argue to reverse
these amounts, but even a system based purely on historical cost is a mix of asset purchase dates; it is not a “clean”
measure, so we leave these revalued assets in place. A second practical reason for not reversing revaluation reserves is that
in some countries, the charges to earnings are based on the revalued asset amounts, which are not possible to tease out.
Finally, while revaluations affect historical measures, they are generally not forecast.
NB In some countries, notably parts of Latin America, there is still some form of inflation accounting, which can lead to
indirect asset revaluations. In these regions, our analysts generally apply the local policies about inflation accounting and
then build these into their forecasts. This adjustment often includes exchange-rate adjustments, so we require the analyst to
specify the exchange rate used so clients can get comparable numbers in the currency they are interested in.

continued

Modelware– August 2, 2004

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 Page 49

Net Operating Assets (NOA) (continued)

Related Valuation/Performance Measures

RNOA, OpATO

Underlying Economic Logic

Q Why are some associated companies treated as operating assets?
A There are businesses where the associated companies accounted for under the equity method are integrally part of the
operating activity. Examples include captive finance companies, the bottlers of mainstream beverage companies like KO
and PEP, R&D partnerships, and so on. To treat these as non-operating would help distort operating performance metrics.
NB When including such investments as operating assets, the asset base and the operating income (NOPAT) go up, but
revenue is not included unless it is adjusted by including proportional consolidation. So while RNOA is not distorted, the
OpATO will be relatively low and the NOPAT relatively high.

Q How are deferred taxes treated?

A In calculating the components of earnings, we compute the tax effect of operating and financing activities; the balance
of actual taxes is reflected in other non-operating items. For the balance sheet, we provide a similar split and ask analysts to
split the deferred taxes based on where the underlying balance sheet amounts are categorized. This is a tough exercise in
many cases, but we expect the split to improve over time. As with all items, where there is doubt we would default to
operating. The one area in which we would usually find an analyst team splitting out a financing component of deferred tax
is for those deferred taxes associated with pensions and post-employment benefits, as these are clearly separated and often
material.

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Net Debt
What’s Measured
• The net financial resources of the businesses.
• Any net obligation reflects the borrowed funds and the
extent of a company’s leverage.
Typical Use
• Net debt is a key component for assessing (with
equity) the capital structure of the firm. This can be used
to assess how shareholder value can be enhanced by
returning excess funds or changing the form of funds
borrowed.
• Net debt can be used to assess potential risk in periods
of negative performance and the potential for the firm to
lever its operating profitability.
ModelWare Approach
• In ModelWare, net debt includes all borrowings,
balance of debt from capitalized operating leases, net
pension obligations, cash and financial investments, and
preferred shares.
• In ModelWare, we make no distinction between short-
and long-term debt, as in today’s economy of financial
flexibility the distinction is quite arbitrary.
• We include other interest-bearing liabilities in net debt.
In particular, asset retirement obligations and nuclear
decommissioning costs that are recorded at present values
and then accreted at the discount rate through time will be
treated as debt.
Modelware– August 2, 2004
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Page 50
Related Valuation/Performance Measures
Debt/Capital, Leverage
Underlying Economic Logic
Q Why are financial assets netted against
borrowings?
A The decision of whether to leave resources in cash
and investments or to pay down debt or return the
capital to shareholders is a decision about cash
management and capital structure. We also based our
classification of financing items on what we would
expect a finance director, chief financial officer or
treasurer to be responsible for in a typical situation.
Q Why are net pension obligations treated as
financing?
A As discussed under operating and financing
expense, we believe that the decision of when to fund
and how to invest funds related to pensions and other
post-employment benefits is a pure financing decision.
A company could have paid the cash when “earned”
and insured the future payment stream. Its choice not
to go this route is a financing choice.
Q Why is preferred stock treated as debt and not
equity?
A The difference between most preferred stock and
debt is that in the former, the coupon and yield is paid in
the form of a dividend, but this is economically
analogous to junior subordinated debt. In contrast,
owners’ equity is the recipient of residual profitability
and bears first losses. To us, the nominal form of
payment is not the best distinguishing feature.
NB If the preferred shares were participating
preference shares (a rare occurrence today), we would
be more inclined to classify them as equity, depending
on the nature of the participation rights.
Q Why is minority not treated as debt?
A Our initial thought was to include minority as debt,
and we view it as more debt-like than equity. But
minority shareholders participate in or own a share of
the financial obligations of a subsidiary. So to treat
them as pure debt seemed inappropriate. Our
conclusion was to treat them as “other non-operating
liability.”
 Page 51

Other Non-Operating Assets (Liabilities)

What’s Measured Underlying Economic Logic

• Balance sheet amounts that are clearly neither See discussion of net operating assets and net debt.
operating or financing in nature.

Typical Use
• This is used to complete the balance sheet and to
understand how significant non-operating and non-
financing components are to the firm. If this is a
proportionately large number, a further breakdown is
needed.

ModelWare Approach
• We include all items that are clearly not operating or
financing in nature. Common items included are associate
companies accounted for as equity investments that are
unrelated to operating activities, and minority interests. We
also include dividends payable, a category that exists in
some countries.

Modelware– August 2, 2004

Please see analyst certification and other important disclosures starting on page 57.

Shareholders’ Equity
What’s Measured
• The equity or net asset value attributable to the
common shareholders (owners) of the business.
Typical Use
• Used to reflect the net investment or “share” of the net
assets belonging to shareholders, primarily for considering
measures of profitability and leverage.
ModelWare Approach
• ModelWare takes an ordinary or common shareholder
(proprietary) perspective and so includes only those
amounts that relate to these shareholders.
• Shareholders’ equity includes the share capital accounts,
treasury stock (or any investment in own shares), other
reserves, other comprehensive income, and retained
earnings.
• In some cases, especially in financial services
companies, we allow for an adjustment of material
unrecognized gains or losses on investments.
Modelware– August 2, 2004
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Page 52
Related Valuation/Performance Measures
ROE, Debt/Capital, Leverage
Underlying Economic Logic
Q Why is treasury stock or investment in own
shares treated as negative equity rather than an
asset?
A It has long been held that companies cannot trade in
their own shares and generate gains and losses in them
or report them as resources. While it is true that some
shareholders may be perceived as having “gained” if
shares are repurchased at a lower price than where they
are reissued, this would always be at the expense of
other shareholders, so considering all shareholders,
there is no real gain or loss.
Q How are unrealized gains or losses on available-
for-sale securities treated?
A For financial services companies where operations
include trading securities, we view the distinction
between available-for-sale and trading as artificial. As a
result, for these companies we include incremental
unrealized gains and losses on available-for-sale
securities in operating income.

Dividends per Share
What’s Measured
• Dividends paid to common shareholders over a period.
Typical Use
• Usually used to see what cash per share is paid out to
shareholders.
• It is primarily used in dividend yield and dividend
payout ratio calculations.
ModelWare Approach
• Dividends per share is a surprisingly difficult metric to
calculate because dividends are frequently paid more often
than once a year, and shares outstanding can be different at
each payment date and at the end of the year. As a result, in
ModelWare we allow the analysts to tag a dividend-per-
share metric.
• If a dividend-per-share metric is not tagged, then we
calculate dividends per share by dividing the total common
dividends by the average basic shares outstanding.
Modelware– August 2, 2004
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Page 53
Related Valuation/Performance Measures
Dividend Payout Ratio, Dividend Yield,
and Return of Capital Ratio
Underlying Economic Logic
Q Is it appropriate to consider dividends per share
as total return of capital per share to shareholders
for the period?
A No. Dividends per share can be quite misleading,
but it was a measure demanded by our analysts because
it is used in dividend yield calculations. From a return
of capital perspective, share repurchases and dividends
are equivalent, subject to (shareholders’) tax
considerations. While all shareholders usually get the
cash dividends, the benefit of share repurchases is
indirect (via the share price) for those shareholders who
do not sell their shares. But economically, for the
company they are essentially the same.
Many people believe (and academic evidence
shows) that dividends seem to have a stronger
“commitment value” and so are considered differently
from other returns of capital.
Q Why are basic, not diluted shares outstanding
used for dividends per share?
A In many cases, dilutive securities do not receive
dividends. Even if they do, it is usually a special case
that would not be generally known. Thus, we decided
to use basic shares. We do provide dividends per share
(diluted) so that the difference can be seen. We also
use the average shares outstanding versus the period
end, on the assumption that the dividends are paid over
time.
NB To the extent that these assumptions are invalid,
they can be superseded by the analyst tagging the
dividends per share

Return of Capital (Gross and Net)
What’s Measured
• The amount of capital returned to shareholders in a
period.
Typical Use
• Used to see what earnings or capital a firm is returning
to shareholders versus reinvesting in the company.
ModelWare Approach
• Return of capital (gross) adds the amount spent on
share repurchases to the dividends paid.
• Return of capital (net) starts with the gross return and
deducts any capital raised from share issuance for employee
share and option plans and the associated tax benefit.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 54
Related Valuation/Performance Measures
Return of Capital Ratio, Return of Capital Yield
Underlying Economic Logic
Q Why are share repurchases considered a return
of capital like dividends?
A Companies choose to reinvest capital or return it to
shareholders. The payment back to shareholders can
be done directly as a dividend to all shareholders
outstanding (but excludes most option or contingent
equity holders) or indirectly by buying back shares.
This reduces the capital to reinvest but should raise the
stock price and thus deliver a “return” to shareholders,
even if they choose not to sell their own shares back to
the company.
Q Why are proceeds netted out from share
issuance related to employee stock and purchase
plans?
A Many companies try to manage their shares
outstanding by buying back the same number of shares
exercised in a given year under an employee share or
option program. In such circumstances, using the gross
amount used for share repurchase would overstate the
true return of capital. We do not include all share
issuance, as those for additional capital-raising
purposes have a different meaning

Market Capitalization and Market Capitalization Basic
What’s Measured
• The market valuation of owners’ equity.
Typical Use
• Market capitalization is used as a component of
enterprise value and many ratios that use aggregate rather
than per share measures.
• Market capitalization is also used as a rough measure of
size.
ModelWare Approach
• We take the view that market prices reflect anticipated
dilution, and so market capitalization is calculated as
current price multiplied by current diluted shares
outstanding.
• In reality, diluted shares are not reported at a period end
or on a constant basis. We compute the diluted shares by
taking the ratio of average diluted to average basic and
applying this to the basic shares outstanding at any point in
time.
• As a result of potential measurement problems in
diluted shares outstanding, we also provide a market
capitalization using basic shares outstanding.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 55
Related Valuation/Performance Measures
P/B, EV/EBITDA, Dividend yield.
Underlying Economic Logic
Q Aren’t diluted shares outstanding overstated in
some cases?
A Companies that have convertible securities that are
out of the money are still required to treat these as if
converted by current accounting rules. In addition, the
use of the “treasury stock” method does not capture the
potential dilution effect of warrants and employee stock
options. But we believe that basic shares outstanding
will generally understate the number of shares used to
price a share. In a later version of ModelWare, we may
move to a measure of diluted shares outstanding more
in line with the underlying economics, but we believed
this was not of the highest priority.
NB The fact that even a simple measure like market
capitalization has measurement issues demonstrates
why investors need to be so careful about assuming too
much precision in any measure.

Enterprise Value (EV)
What’s Measured
• In concept, EV is the market’s valuation of the entity.
In practice, it is usually a measure of the value applied to
the operating business.
Typical Use
• EV is primarily used to calculate market-based
performance ratios where the other measure used is an
operating measure.
• It is used as an operating-level equivalent to P/E or P/B,
although measurement issues with EV and related measures
are much more problematic.
ModelWare Approach
• We start with market capitalization, plus market value
of net debt or (where market value is unavailable) book
value of net debt. Net debt includes the capitalized
operating leases and economic measure of net pension
obligations (see net debt). We then add minority interests
and other non-operating assets or liabilities that are
considered part of the “funding” of net operating assets.
• In some cases, there are substantial investments
(especially in associated companies) that are non-operating
but have an impact on market capitalization. When no
operating earnings or net operating assets are related to
these investments, we eliminate them when using EV in any
valuation or performance measure that uses them.
Modelware– August 2, 2004
Please see analyst certification and other important disclosures starting on page 57.
Page 56
Related Valuation/Performance Measures
EV/EBITDA, EV/NOA
Underlying Economic Logic
Q Why is it appropriate to include market value of
net debt; how often is this actually used, and what
does EV mean when it is not?
A The concept of EV is the market’s valuation of the
net operating business, analogous to market
capitalization as the market’s value of shareholders’
equity. Conceptually, only the market value of debt
makes sense. In practice, however, we have found the
use of market value by analysts to be rare, with book
value of debt used as a substitute. If the components of
net debt have variable rates of interest, this should not
matter, but if there is any fixed-rate debt, enterprise
value measurements will include errors; the larger this
relative amount, the more meaningless EV becomes.
Q How should EV be calculated when considering
historical or future periods?
A For historical periods, we would use EV as
measured on the last date of the period. For future
periods, the market capitalization should not change, as
it is too arbitrary to decide what future events are already
anticipated in the current price. A similar argument
would apply if the market value of debt or other included
items were used, but if book value is used, the future EV
should be adjusted for forecast book values.
Q Why are other non-operating items included?
A Our identification of other non-operating items
includes those assets/liabilities that are clearly non-
operating. So if the objective of EV is to get a “market”
valuation of the NOA from the “funding” side, it is
important to include all non-operating items.
NB One potentially significant component of other non-
operating assets/(liabilities) we include is minority
interests. As with debt, these should be measured at
market value, but this requires the subsidiary to be
known and listed. This is often not the case, so the book
value is used, again raising measurement questions as to
what EV really means.
The above discussion should make it clear that in
practice EV is a number fraught with potentially
insoluble measurement problems, so we would be very
cautious in interpreting such measures.
 Page 57

Analyst Certification
The following analysts hereby certify that their views about the companies and their securities discussed in this report are
accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for
expressing specific recommendations or views in this report: Trevor Harris.

Important US Regulatory Disclosures on Subject Companies

The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and its affiliates (“Morgan
Stanley”).
The research analysts, strategists, or research associates principally responsible for the preparation of this research report have
received compensation based upon various factors, including quality of research, investor client feedback, stock picking,
competitive factors, firm revenues and overall investment banking revenues.

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ModelWare – August 2, 2004

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