A traditional approach to determining the value of securities is the discounted free cash flow (DCF) valuation method. This approach is based on a series of assumptions about the growth of the company's business performance drivers.
For example, a person taking a DCF approach might estimate the number of iPods Apple will sell or the number of stores Starbucks will open. Using this information, he or she would use subjective and/or quantitative processes to draw conclusions about the valuation of a company's stock.
The RBP® approach reverses the traditional DCF sequence. The methodology starts with the underlying value of the stock as determined by the market price.
This market price is coupled with the latest financial information to work backwards to determine the company's required business performance: That is, how much revenue the company must generate to substantiate the price of the stock.
Even beyond the required revenue, the RBP® methodology works all the way back through the company's business model to the most granular level to determine, for example, how many iPods Apple has to sell and stores Starbucks must open.
But calculating the performance necessary to support the price of the stock is only one half of the equation, because the RBP® alone doesn't address whether the management of a company can actually deliver the required business performance.
The question becomes: Can it be done? Can a company actually deliver the required business performance necessary to substantiate the price of the stock? The probabilities arrived at through the reverse DCF methodology seeks to measure the likelihood that the management of a company can deliver the RBP®.
These probabilities--which are the cornerstone of the Dow Jones RBP IndexesSM--provide a rules-based transparent means of measuring whether management can perform in the future in the way that substantiates the company's current value. The RBP® methodology reduces the complexity of valuation to its basic components.
To calculate the RBP® probability for a given company, the RBP® is calculated for ten years in the future. Historical revenue is collected from each of the prior twelve quarters.
After fitting a distribution curve to the data, the RBP® probability is calculated. Higher weightings are assigned to those periods with revenue numbers that are determined to be relevant to future performance.
In this way, the RBP® probability measures the likelihood that a company will deliver the performance that has been priced into the stock, based on a company's past performance.
© Dow Jones & Company, Inc. 2009. All rights reserved.
Dow Jones®, "Dow Jones Indexes", "Dow Jones RBP Indexes", "Dow Jones RBP U.S. 130/30 Indexes" and "Dow Jones U.S. Large-Cap Total Stock Market Indexes" are service marks of Dow Jones & Company, Inc.
"Transparent Value", "Required Business Performance" and "RBP" are service marks of Transparent Value, LLC.
Inclusion of a company in any of the indexes in this piece does not in any way reflect an opinion of Dow Jones, Transparent Value or any of their affiliates on the investment merits of such company. None of Dow Jones, Transparent Value or any of their affiliates is providing investment advice in connection with these indexes.
The Dow Jones RBP Indexes are rebalanced quarterly. Company examples featured on this page may or may not be current index components.
The RBP® and RBP® probability methodologies are the subject of a Transparent Value LLC patent application filed with the United States Trademark and Patent Office.