Lumen R4A FAQ
What is Ke?
Lumen’s Ke is an assessment of the market-implied expected return, a.k.a. intrinsic value or cost of equity, and the Yield-to-Maturity for fixed income. Its unique attributes are that it is unbiased (not dependent on the subjective forecast), universal (using one single metric across all assets & investments), and forward-looking (not dependent on the rear-view mirror and exposed to data mining) … just what the market implies.
How is the Ke calculated?
Using live market data, a reverse engineering algorithm, and a proprietary, unbiased, universal, and forward-looking application of the most powerful law of finance stating that: the monetary value of any and all investments is equal to the sum of the future cash flow discounted back to present value; the discount rate applied is thus equivalent to the market expected return and/or intrinsic value.
Is the Ke a better value metric than the Multiples (P/E, P/BV, P/S, etc.)?
Yes! The Ke is a direct application of the most powerful law in finance mentioned above; thus, Ke is calculated using the gold standard of universal valuations. Multiples instead have nothing to do with economic and financial value as they are a market price divided by an accounting suggestion susceptible to legitimate tweaks and machinations. They are at best market momentum indicators (link to paper).
Is the Ke a good indicator of future returns?
If one assumes that markets are efficient and always right, the Ke is the most relevant, impartial, and straightforward estimate of equilibrium intrinsic value … ceteris paribus!
How to best “use” the Ke?
Given that markets are not always right and efficient, the best use of the Ke is for ranking in internally consistent matter markets, asset classes, and all investment opportunities, in general, using one single, unbiased, universal, and forward-looking intrinsic value metric … i.e., use the Ke unbiased and universal ranking as the crucial starting point in asset allocation exercise and/or portfolio construction.
How does the Ke improve the Black-Litterman Model?
Albeit theoretically brilliant, the B&L construct (link to paper) relies heavily on a set of inestimable data (the equilibrium global market cap), and history (the rear-view mirror) to estimate the implied market return, thus undermining the practical application and biasing the results … as admitted by the authors. Given the proven attributes of the Ke (unbiased, universal, and forward-looking) the Ke instead is a much better candidate for the B&L construct, empirically generating much better risk-adjusted results (see paper).
What is the Black Litterman Model?
The B&L model combines information from two sources to create an estimate of expected return:
Source 1 – What does the market tell us about the current value? I.e., market implied return.
Source 2 – What subjective views do investors have about particular investments?
Combining the two estimates and applying a complex Bayesian Estimator generates a more coherent, intuitive, and rational set of expected returns, thus generating by construction optimal and diversified portfolios with superior risk-adjusted attributes and performance potentials, without applying arbitrary limits and constraints to the optimizer.
What are the Four Pillars of Value?
Any and all investments can be assessed by four fundamental metrics:
- Does the investment generate profits? Proxied in R4A by ROE.
- How much capital does the investment use to generate that profit? Proxied by Financial Leverage (Assets over Equities).
- What is the cost of that capital? Estimated by the Ke.
- What is the growth expectation? Proxied by Sales/EPS Growth.
… everything else is details.
What are the screening metrics available in R4A?
R4A screening and selection of investment possibilities are based on three traditional approaches:
Fundamentals (cash flow) using the Four Pillars of Value.
Multiples, using P/E, P/BV, Dividend Yield.
Historical Price Performance, using 1, 3, and 5-year total returns.
How are the Factors determined in R4A?
R4A follows the industry’s standard to classify stocks across main factors: size, value, growth, volatility, momentum, quality, and dividend … with one notable and unique exception: we do not use Multiples as metrics of value. R4A instead applies the economic value concept to measure value (Economic Value Added – EVA), proxied as the difference between net profits and costs, or ROE minus Ke.