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Lauren Soulis lsoulis@smu.edu Philip Griffin pngriffi@smu.edu Bill Rugg wrugg@smu.edu

Recommendation: SELL

WAG CVS Comp. Agg. Current Price: $ 45.16 $ 24.38 Market Cap: $ 46.44 B $ 19.82 B P/E (ttm): 25.5 20.38 19.7 P/E (fwd): 22.14 15.14 19.3 PEG (5 yr fwd): 1.54 1.40 1.3 EV/EBITDA: 15.471 10.079 11.279 Debt Rating A+ A-

Walgreen Co. NYSE: WAG

Consumer Sector Drug Retailing

11/3/2005 Key Points:

• Overvalued on DCF and comparable basis. • Underperforming drug retailing segment. • Institutional holdings reflect a significant net sale of

holdings. Insiders have sold 249,716 shares in past 12 months vs. 640 shares purchased. Conveys a lack of confidence in future prospects for WAG.

• Proposed changes in the structure of Medicaid reimbursement fee calculation could put pressure on margins at the retail level, encouraging further consolidation.

• WAG is largest drug retailer by market cap, but CVS is a formidable competitor with more locations and fewer employees.

• Stiffer competition will lead to erosion in margins. • Gross margin growth rates have decelerated by .04%

over the past five years. • No long-term debt—not necessarily a positive. • Half of their stores are less than 5 years old.

Company Overview: Walgreens is a drug-retailer that sells prescription and nonprescription drugs as well as other healthcare products and general merchandise (toiletries, cosmetics, household goods, a limited offering of food and beverages, and photofinishing.) Walgreen Co. is the largest company in the drug retailing sub-sector ($43.86B market cap) and one of the largest within consumer staples. They operate 5,000 retail locations in 45 states and Puerto Rico, as well as internet and mail-order pharmacies. Through its strong organic growth initiatives, Walgreen Co. has more than doubled the number of stores it operates in the past 10 years. In this time it has distinguished itself as the leading drug retailer by market cap and sales through strong revenue and earnings growth. They plan to operate more than 7,000 locations by 2010. Investment Thesis: This year, Walgreens has acquired two smaller drug chains in an effort to continue strengthening its market position (a break-away from its traditional method of growth.) CVS, historically a serial acquirer, operates more locations and has established itself as a serious competitor to Walgreens’ claim to the number one position. While the population is aging and demand for health care products is predicted to increase as a result, we are not optimistic about Walgreen’s ability to maintain margins and market share in a climate of increasing competition and erosion of leverage with drug wholesalers. (See discussion below about comp sales and gross margin compression.) Many describe Walgreens’ organic growth, strong cash position and lack of long-term debt as qualities that make it “best of breed.” We question management’s discipline and ability to invest in projects that improve Walgreen Co.’s competitive position with cash to spend and no debt to service.

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Indications of Slowing Growth: Same store sales, or sales figures for locations open at least one year, indicate that growth in revenues may not be sustainable at historic rates. For six of the past seven months comp sales have been below the average for the trailing twelve month period. Furthermore, total store sales year-over-year (including newly opened locations) for those same six months were also below the trailing twelve month average. While some of the slower growth could be attributable to exogenous economic factors (i.e. rising interest rates and lower consumer spending) it is reasonable to expect performance to remain stable during this economic climate. Whether partly due to economic factors or not, it is clear that sales growth is decelerating at least in the short-term. Slower growth in the short-term could be a symptom of increasing competition, market saturation and maturation of the company as a whole. It is unreasonable to believe that there is unlimited demand in the market for pharmaceutical products.

Comp Sales Total Sales Apr-05 5.3 % 9.6 %

May-05 8.8 13.5 Jun-05 7.8 12 Jul-05 5.9 10

Aug-05 7 11.7 Sep-05 7.7 10.9 Oct-05 6.5 9

12 mo. Avg. 7.97 12.05 Std Dev 2.24 2.41

Macro Outlook: Knowing that consumer staples and health care sectors tend to be less sensitive to rising interest rates and energy costs than more cyclical sectors like consumer discretionary and technology, the drug retailing sub-sector is positioned well in the current economic climate. The continuation of the interest rate tightening cycle, marked by the eleventh consecutive quarter-point increase in interest rates by the Fed, combined with high oil prices leads to the reasonable conclusion that a deceleration in spending on discretionary items will continue in the near term. Additionally, with the aging population will inevitably come an increase in demand for prescription drugs and cosmetics as a growing number of people need pharmaceutical help to stay healthy and looking young. This growth in consumers supports the rationale for the aggressive expansion characteristic to the drug chain growth model. The question then becomes, at what point will consumer demand be fully supported by the drug retailers? Market Sentiment: Volume of short selling has increased over the past three months—an indication that the Street is possibly becoming more bearish on Walgreens.

Short Interest

Month Shares

(Mil) %

Outs. %

Float Days

10/10/05 16.514 1.626 1.637 3.479

09/08/05 14.594 1.437 1.447 5.437

08/08/05 13.249 1.305 1.313 5.379

07/08/05 13.277 1.307 1.316 4.844

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Source: www.reuters.com

Valuation— Discounted Cash Flow Analysis: Assuming continued earnings growth at consensus estimates, with modest margin compression, our model fairly values Walgreens with a price target of $61.50 per share. So, assuming continued growth at historical earnings growth rates, Walgreens is a very attractive buy. This intrinsic valuation includes a beta assumption of .5 which is roughly splitting the difference between the .3 and .87 reported by different sources. A beta of .3 produces a price target of over $200 per share versus approximately $26 per share with a beta of .87 holding all other assumptions constant. Furthermore, this scenario includes an increase in capital spending for FY06 as projected in the FY05 WAG press release. After 2006 the model trends capital spending back down to the historical average of 2.5 times depreciation. If the cash flows are modeled assuming FY06 growth more in-line with the fiscal year 2005, and slightly more margin compression, the intrinsic value is calculated to be $37.48 per share. (Assuming the same beta of .5.) Under this scenario of expected revenue growth in FY06 of 12.5%, COGS growth of 11.5% and SGA growth of 15.5%, Walgreens would still realize above-average earnings growth of 16.71% for the year.

Key Assumptions for the models: Date of valuation 11/3/2005 Risk Free Rate: 3.50% Equity Market Risk Premium: 7.00% Long term inflation: 2.50% Terminal Growth: 5.00% Equity beta: 0.5 No. of shares (diluted): 1,028 Current Market Price per share: $45.16

Valuation model used Summary

Equity $M $ Per Share Unlevered value $38,526 $37.47 Adjusted Present Value $38,526 $37.47 Flow to Equity $38,562 $37.50 WACC with FCF $38,524 $37.46 AT-WACC with UFCF $38,535 $37.47 Average across models $38,537 $37.48 Price deviation across models $1 0.1%

Five valuation techniques were used to arrive at the intrinsic value and a price deviation of .1% existed across the models for the scenario with the margin compression we feel is going to occur. As Walgreen Co. has no meaningful long-term debt, the unlevered value is essentially the same as the other valuation models. For further detail of the DCF analysis, see below exhibits.

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Comparable Analysis:

Aggregate Company Name Walgreen CVS for Rite-Aid Wal-Mart Best Buy Starbuck's Ticker WAG CVS Comps RAD WMT BBY SBUX (LFY Income Statement): Latest Fiscal Year End Date 9/30/2005 Revenue (billions) $42.20 $30.59 $410.30 $16.79 $287.99 $27.43 $5.29 Gross Profit $11.79 $8.03 $101.82 $4.21 $68.20 $6.50 $3.10 EBITDA $3.00 $1.95 $30.17 $0.68 $21.70 $1.90 $0.95 (Per Share Income Statement Data) LTM Sales $40.24 $43.68 $32.31 $298.46 $28.69 $6.16 LTM EPS* $1.53 $1.20 $0.34 $2.54 $2.14 $0.58 CFY EPS Estimate 2005 $1.77 $1.38 $0.04 $2.64 $2.17 $0.60 NFY EPS Estimate 2006 $2.04 $1.61 $0.11 $3.00 $2.55 $0.74 (Stock Data): Stock Price As Of: 10/31/05 10/31/05 10/31/05 10/31/05 10/31/05 10/31/05 Stock Price $45.16 $24.38 $3.56 $47.31 $44.26 $28.15 Common Shares Outstanding 1.028 0.8 0.52095 4.16 0.48772 0.76847 Market Capitalization (MV of Equity) $46.44 $19.82 $308.14 $1.85 $196.81 $21.59 $21.63 Total Mkt. Capitalization $46.45 $22.66 $351.03 $4.88 $232.89 $22.14 $22.01 Enterprise Value $45.08 $22.24 $340.31 $4.79 $227.22 $19.31 $21.66 (Profitability ) WAG CVS RAD WMT BBY SBUX LFY Gross Margin 27.9% 26.2% 24.8% 25.1% 23.7% 23.7% 58.6% LFY EBITDA Margin 7.1% 6.4% 7.4% 4.0% 7.5% 6.9% 17.9% ROE 18.3% 14.2% 30.32% 122.18% 23.6% 24.4% 20.1% ROA 11.1% 11.2% 34.33% 4.73% 9.44% 10.43% 14.13% (Growth/Return): Historical 3 Year Revenue Growth Rate 12.20% 11.4% 2.80% 7.00% 10.40% 22.30% Historical 3 Year EPS Growth Rate 14.1% 23.7% 55.60% 12.70% 37.90% 27.00% Proj. Growth in EPS 5 Years 16.2% 13.0% 15.06% 8.77% 14.7% 16.0% 26.46% Dividend Yield 0.6% 0.5% 0% 1.40% 0.80% 0.00% (Valuation): MV of Equity / Book Value 5.2 2.2 6.8 -8.5 17.2 2.2 3.7 Price/Sales (TTM) 1.1 0.7 0.11 0.16 1.54 4.57 Price / EPS (TTM) 29.7 20.3 22.6 10.5 18.6 20.7 48.5 Price / EPS (05) 25.5 17.7 19.7 89.0 17.9 20.4 46.9 Price / EPS (06) 22.1 15.1 19.6 32.4 15.8 17.4 38.0 Total Mkt Capitalization / EBITDA 15.5 11.6 11.6 7.2 10.7 11.6 23.2 PEG 05 to 3-5 yr growth 1.6 1.4 1.3 10.1 1.2 1.3 1.8 EV/EBITDA 15.034 11.399 11.279 7.097 10.472 10.152 22.853 (Supplemental Statistics): Number of Stores 5,000 5,375 3,357 5,379 769 8,700 Number of FT Employees 117,000 78,500 38,448 1,700,000 109,000 N/A *Excl. extra. Items, writeoffs, & one time charges

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Comparable Analysis Continued: The comparable aggregate prices Walgreens at $34.69 per share on a forward P/E basis, using FY06 consensus estimates. This coincides with our price target from DCF and supports the argument that Walgreens is trading expensive relative to its peers. On an EV/EBITDA basis the comp. aggregate suggests a fair value of $33.96 per share.

WAG actual Comp. Agg. Fair Value Price / EPS (ttm) 25.5 19.7 $ 30.14 Price / EPS (fwd) 22.1 19.6 $ 34.69 EV / EBITDA 15.03 11.28 $ 33.96 Price / Book 5.09 4.28 $ 38.04 EV / Net Income (FY06) 25.46 21.73 $ 38.46 Average Price: $ 35.06

On a trailing basis Walgreens looks especially expensive due to soft Q4 and FY05 earnings. Despite unimpressive earnings for 2005 (partially due to a $54.7 M pre-tax charge for expenses related to Hurricane Katrina,) the stock has performed well since the earnings announcement. We see the modest earnings in FY05, however, as another indicator of a slowdown in growth.

source: BigCharts.com

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Risks to these Opinions: The main risk in the aforementioned assumptions and investment thesis is a return to historic growth levels and stable margins that are unaffected by the competitive climate. If proposed legislation to change Medicaid reimbursement procedures does not materialize, there is less risk for margin compression. It is reasonable, however, that other competitive issues could put pressure on market share and profitability even if they are unscathed by changes to Medicaid. Competitive Environment: Aside from the rivalry between Walgreens and CVS, competition could intensify significantly depending on the fate of Albertsons. Albertsons, which operates both supermarkets and drug stores (Osco Drug and Sav-on Drugs,) announced in September that it is putting itself up for sale. This is significant because they are the fourth largest player in drug retailing by dollar volume and the top supermarket chain by pharmacy sales. Kroger, the second largest supermarket chain by pharmacy sales is one of the four companies that have placed bids for Abertsons. The other three bidders are drug retailers (CVS, Walgreen Co., and Rite Aid) that have bid solely on Albertsons’ drugstores. A deal with any of these bidders could significantly affect the competitive environment both due to the size of the players involved and the regional strength of the Osco and Sav-on chains.

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Walgreen

Annual Historical and Projected Income Statement

(Dollars in Thousands)

Year -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Terminal

Total Revenue 21,206.90$ 24,623.00$ 28,681.10$ 32,505.40$ 37,508.20$ 42,202 48,668 55,230 61,783 68,234 74,504 80,528 86,258 91,659 96,710 101,400

Total Cost of Goods Sold 15,465.90 18,048.90 21,076.10 23,706.20 27,310.40 30,414 35,060 39,773 44,478 49,108 53,607 57,928 62,038 65,910 69,531 72,893

Gross Profit 5,741 6,574 7,605 8,799 10,198 11,788 13,608 15,457 17,305 19,126 20,897 22,600 24,221 25,749 27,179 28,507

SG&A (SHOULD EXCLUDE DEPR.) 4,287 4,907 5,674 6,605 7,652 8,827 10,203 11,602 13,003 14,384 15,729 17,023 18,255 19,418 20,506 21,518

Depreciation and Amortization 230.10 269.20 307.30 346.10 403.10 482 476 548 608 667 732 804 882 969 1,063 1,167

Total Dep'n and SGA 4,517 5,176 5,981 6,951 8,055 9,309 10,679 12,151 13,611 15,051 16,461 17,826 19,137 20,386 21,570 22,685

Operating Income 1,224 1,398 1,624 1,848 2,143 2,479 2,929 3,306 3,694 4,075 4,437 4,774 5,084 5,363 5,609 5,822

Other (non-operating) Income / (Expense) 31 40 28 13.10 40.40 33.60 38 44 49 55 61 67 72 77 82 87 91

EBIT, Earnings Before Interest and Taxes 1,264 1,426 1,637 1,889 2,176 2,517 2,973 3,356 3,750 4,137 4,503 4,846 5,161 5,445 5,696 5,913

forced to zero in L-PInterest Expense 0.40 3.10 1 1 1 - - - - - - - - - - -

Other (non-recurring) Charges (pretax) - - - - - - - - - - - - - - -

EBT, Earnings Before Taxes 1,263 1,423 1,637 1,888 2,176 2,517 2,973 3,356 3,750 4,137 4,503 4,846 5,161 5,445 5,696 5,913

Income Taxes (payable) 486.40 537.10 618.10 713 816.10 944 1,115 1,258 1,406 1,551 1,689 1,817 1,935 2,042 2,136 2,217

Tax Rate 37.9% 38.5% 37.8% 37.8% 37.8% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5%

Net Income 777$ 886$ 1,018$ 1,175$ 1,359$ 1,573$ 1,858$ 2,097$ 2,343$ 2,585$ 2,815$ 3,029$ 3,226$ 3,403$ 3,560$ 3,695$

Growth Assumptions: Trend: Historic growth

Revenue Growth Sequential 0.88 15.32% 16.1% 16.5% 13.3% 15.4% 12.5% 15.3% 13.5% 11.9% 10.4% 9.2% 8.1% 7.1% 6.3% 5.5% 4.8%

COGS Growth 0.88 15.28% 16.7% 16.8% 12.5% 15.2% 11.4% 15.3% 13.4% 11.8% 10.4% 9.2% 8.1% 7.1% 6.2% 5.5% 4.8%

SGA Growth 0.88 15.59% 14.5% 15.6% 16.4% 15.9% 15.4% 15.6% 13.7% 12.1% 10.6% 9.3% 8.2% 7.2% 6.4% 5.6% 4.9%

Derived Income growth 15.00% 15.37% 15.70% 15.69% 18.14% 12.88% 11.73% 10.32% 8.86% 7.61% 6.50% 5.50% 4.61% 3.80%

As a Percent of Sales:

Total Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Total Costs of Goods Sold 72.9% 73.3% 73.5% 72.9% 72.8% 72.1% 72.0% 72.0% 72.0% 72.0% 72.0% 71.9% 71.9% 71.9% 71.9% 71.9%

Gross Profit 27.1% 26.7% 26.5% 27.1% 27.2% 27.9% 28.0% 28.0% 28.0% 28.0% 28.0% 28.1% 28.1% 28.1% 28.1% 28.1%

SG&A (SHOULD EXCLUDE DEPR.) 20.2% 19.9% 19.8% 20.3% 20.4% 20.9% 21.0% 21.0% 21.0% 21.1% 21.1% 21.1% 21.2% 21.2% 21.2% 21.2%

Depreciation and Amortization 1.1% 1.1% 1.1% 1.1% 1.1% 1.1% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.1% 1.1% 1.2%

Operating Profit Margin (Excl. Depr. & Amort.) 6.9% 6.8% 6.7% 6.8% 6.8% 7.0% 7.0% 7.0% 7.0% 6.9% 6.9% 6.9% 6.9% 6.9% 6.9% 6.9%

Net Income 3.7% 3.6% 3.6% 3.6% 3.6% 3.7% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% 3.7% 3.7% 3.7% 3.6%

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Walgreen Income Statement with Margin Compression

Annual Historical and Projected Income Statement

(Dollars in Thousands)

Year -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Terminal

Total Revenue 21,206.90$ 24,623.00$ 28,681.10$ 32,505.40$ 37,508.20$ 42,202 47,477 52,699 57,801 62,724 67,426 71,874 76,046 79,931 83,524 86,829

Total Cost of Goods Sold 15,465.90 18,048.90 21,076.10 23,706.20 27,310.40 30,414 33,911 37,343 40,669 43,856 46,881 49,726 52,381 54,843 57,111 59,190

Gross Profit 5,741 6,574 7,605 8,799 10,198 11,788 13,565 15,356 17,132 18,868 20,546 22,148 23,665 25,088 26,413 27,639

SG&A (SHOULD EXCLUDE DEPR.) 4,287 4,907 5,674 6,605 7,652 8,827 10,195 11,602 13,026 14,449 15,855 17,227 18,554 19,826 21,036 22,178

Depreciation and Amortization 230.10 269.20 307.30 346.10 403.10 482 476 548 608 667 732 804 882 969 1,063 1,167

Total Dep'n and SGA 4,517 5,176 5,981 6,951 8,055 9,309 10,671 12,150 13,634 15,116 16,587 18,030 19,436 20,794 22,099 23,345

Operating Income 1,224 1,398 1,624 1,848 2,143 2,479 2,895 3,206 3,497 3,752 3,959 4,118 4,229 4,293 4,314 4,293

Other (non-operating) Income / (Expense) 31 40 28 13.10 40.40 33.60 38 43 47 52 56 60 64 68 72 75 78

EBIT, Earnings Before Interest and Taxes 1,264 1,426 1,637 1,889 2,176 2,517 2,937 3,253 3,549 3,808 4,019 4,182 4,297 4,365 4,389 4,371

forced to zero in L-PInterest Expense 0.40 3.10 1 1 1 - - - - - - - - - - -

Other (non-recurring) Charges (pretax) - - - - - - - - - - - - - - -

EBT, Earnings Before Taxes 1,263 1,423 1,637 1,888 2,176 2,517 2,937 3,253 3,549 3,808 4,019 4,182 4,297 4,365 4,389 4,371

Income Taxes (payable) 486.40 537.10 618.10 713 816.10 944 1,101 1,220 1,331 1,428 1,507 1,568 1,611 1,637 1,646 1,639

Tax Rate 37.9% 38.5% 37.8% 37.8% 37.8% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5%

Net Income 777$ 886$ 1,018$ 1,175$ 1,359$ 1,573$ 1,836$ 2,033$ 2,218$ 2,380$ 2,512$ 2,614$ 2,686$ 2,728$ 2,743$ 2,732$

Growth Assumptions: Trend: Historic growth

Revenue Growth Sequential 0.88 15.32% 16.1% 16.5% 13.3% 15.4% 12.5% 12.5% 11.0% 9.7% 8.5% 7.5% 6.6% 5.8% 5.1% 4.5% 4.0%

COGS Growth 0.88 15.28% 16.7% 16.8% 12.5% 15.2% 11.4% 11.5% 10.1% 8.9% 7.8% 6.9% 6.1% 5.3% 4.7% 4.1% 3.6%

SGA Growth 0.89 15.59% 14.5% 15.6% 16.4% 15.9% 15.4% 15.5% 13.8% 12.3% 10.9% 9.7% 8.7% 7.7% 6.9% 6.1% 5.4%

Derived Income growth 15.00% 15.37% 15.70% 15.69% 16.71% 10.77% 9.09% 7.30% 5.54% 4.05% 2.74% 1.59% 0.54% -0.40%

As a Percent of Sales:

Total Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Total Costs of Goods Sold 72.9% 73.3% 73.5% 72.9% 72.8% 72.1% 71.4% 70.9% 70.4% 69.9% 69.5% 69.2% 68.9% 68.6% 68.4% 68.2%

Gross Profit 27.1% 26.7% 26.5% 27.1% 27.2% 27.9% 28.6% 29.1% 29.6% 30.1% 30.5% 30.8% 31.1% 31.4% 31.6% 31.8%

SG&A (SHOULD EXCLUDE DEPR.) 20.2% 19.9% 19.8% 20.3% 20.4% 20.9% 21.5% 22.0% 22.5% 23.0% 23.5% 24.0% 24.4% 24.8% 25.2% 25.5%

Depreciation and Amortization 1.1% 1.1% 1.1% 1.1% 1.1% 1.1% 1.0% 1.0% 1.1% 1.1% 1.1% 1.1% 1.2% 1.2% 1.3% 1.3%

Operating Profit Margin (Excl. Depr. & Amort.) 6.9% 6.8% 6.7% 6.8% 6.8% 7.0% 7.1% 7.1% 7.1% 7.0% 7.0% 6.8% 6.7% 6.6% 6.4% 6.3%

Net Income 3.7% 3.6% 3.6% 3.6% 3.6% 3.7% 3.9% 3.9% 3.8% 3.8% 3.7% 3.6% 3.5% 3.4% 3.3% 3.1%

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Walgreen increases in cash are less than a percent of current year's sales

Annual Historical and Projected Balance Sheet -1.48% 0.80% 0.15% 0.10% 0.06% 0.03% 0.01% -0.01% -0.02% -0.03%

(Dollars in Thousands) (625) 389 81 62 43 25 9 (6) (20) (31)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Terminal

Cash and Equivalents (Including MS) 12.80$ 16.90$ 449.90$ 1,268.00$ 1,695.50$ 1,071 1,460 1,541 1,603 1,647 1,672 1,681 1,674 1,655 1,624 1,583

Accounts Receivable 614.50 798.30 954.80 1,017.80 1,169.10 1,396 1,517 1,721 1,926 2,127 2,322 2,510 2,689 2,857 3,014 3,161

Inventories 2,830.80 3,482.40 3,645.20 4,202.70 4,738.60 5,593 6,148 6,977 7,805 8,620 9,412 10,174 10,897 11,580 12,218 12,810

Other Current Assets 92.00 96.30 116.60 120.50 161.20 256 209 237 266 293 320 346 371 394 416 436

Total Current Assets 3,550 4,394 5,167 6,609 7,764 8,316 9,335 10,477 11,600 12,687 13,727 14,710 15,631 16,485 17,271 17,990

PPE and Intangibles, Net 3,428.20 4,345.30 4,591.40 4,940.00 5,446.40 6,165 7,112 7,895 8,658 9,511 10,446 11,472 12,599 13,836 15,194 16,685

Investments - - - - - - - - - - -

Other Long Term Assets 125.40 94.60 120.90 107.80 131.30 127 170 193 216 239 261 282 302 321 339 355

Total Long Term Assets 3,554 4,440 4,712 5,048 5,578 6,292 7,282 8,089 8,874 9,750 10,707 11,754 12,901 14,157 15,533 17,040

Total Assets 7,104$ 8,834$ 9,879$ 11,657$ 13,342$ 14,608$ 16,616$ 18,566$ 20,473$ 22,437$ 24,434$ 26,465$ 28,532$ 30,642$ 32,804$ 35,030$

Accounts Payable and Accrued Liabilities 1,364.00 1,546.80 1,836.40$ 2,407.80$ 2,641.50$ 2,918 3,427 3,890 4,351 4,805 5,247 5,671 6,075 6,455 6,811 7,141

inc tax Other Current Liabilities 940 1,465 1,119 1,263.60 1,436.40 1,563 1,864 2,115 2,366 2,613 2,853 3,084 3,303 3,510 3,704 3,883

Notes and LT Debt due 1 1 1 1.00 1.00 1 - - - - - - - - - -

Total Current Liabilities 2,305 3,013 2,956 3,672 4,079 4,482 5,291 6,005 6,717 7,418 8,100 8,755 9,378 9,965 10,514 11,024

Other Long Term Liabilities 566 615 693 790 1,036 1,238 1,265 1,436 1,606 1,774 1,937 2,094 2,243 2,383 2,514 2,636

Long Term Debt 11 11 11 11 11 13 15 - - - - - - - - -

Total Long Term Liabilities 577$ 626$ 704$ 801$ 1,047$ 1,251$ 1,281$ 1,436$ 1,606$ 1,774$ 1,937$ 2,094$ 2,243$ 2,383$ 2,514$ 2,636$

Total Stockholders' Equity 4,222 5,195 6,218 7,184 8,216 8,876 10,044 11,125 12,150 13,245 14,396 15,616 16,911 18,294 19,776 21,369

Total Liabilities and Stockholders' Equity 7,104 8,834 9,879 11,657 13,342 14,608 16,616 18,566 20,473 22,437 24,434 26,465 28,532 30,642 32,804 35,030

8.40% Total Debt for leverage calculations 12 12 12 12 12 14 15 17 19 21 23 25 26 28 29 30

Total Debt and Stock 4,234 5,207 6,230 7,196 8,228 8,889 10,060 11,143 12,169 13,266 14,419 15,641 16,938 18,322 19,805 21,400

Net Working Capital (Current Assets Minus Current Liabilities) (Inc. Normal Cash, ex. Debt due) 2,938 3,687 3,835 4,043 4,473 4,883 5,269 5,627 5,955 6,253 6,520 6,757 6,966

Change in Net Working Capital + Normal Cash 749 149 208 429 410 386 358 328 298 267 237 208

As A Percent of Sales: Trend

Cash 0.93 0.1% 0.1% 1.6% 3.9% 4.5% 4.2% 3.0% 2.8% 2.6% 2.4% 2.2% 2.1% 1.9% 1.8% 1.7% 1.6%

Accounts Receivable 2.9% 3.2% 3.3% 3.1% 3.1% 3.1% 3.1% 3.1% 3.1% 3.1% 3.1% 3.1% 3.1% 3.1% 3.1% 3.1%

Inventories 13.3% 14.1% 12.7% 12.9% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6%

Other Current Assets 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4%

PPE and Intangibles, Net 16.2% 17.6% 16.0% 15.2% 14.5% 14.6% 14.6% 14.3% 14.0% 13.9% 14.0% 14.2% 14.6% 15.1% 15.7% 16.5%

Investments 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

0.4% Other Long Term Assets 0.6% 0.4% 0.4% 0.3% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4% 0.4%

Accounts Payable and Accrued Liabilities 6.4% 6.3% 6.4% 7.4% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0%

Other Current Liabilities 4.4% 5.9% 3.9% 3.9% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8% 3.8%

Notes and LT Debt due 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

2.6% Other Long Term Liabilities 2.7% 2.5% 2.4% 2.4% 2.8% 2.6% 2.6% 2.6% 2.6% 2.6% 2.6% 2.6% 2.6% 2.6% 2.6% 2.6%

Long Term Debt 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Total Stockholders' Equity 19.9% 21.1% 21.7% 22.1% 21.9% 21.0% 20.6% 20.1% 19.7% 19.4% 19.3% 19.4% 19.6% 20.0% 20.4% 21.1%

-0.007 Total Debt for leverage calculations 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

As A Percent of Nomal Assets

Cash 0.2% 0.2% 4.6% 10.9% 12.7% 7.3% 8.8% 8.3% 7.8% 7.3% 6.8% 6.4% 5.9% 5.4% 4.9% 4.5%

Accounts Receivable 8.7% 9.0% 9.7% 8.7% 8.8% 9.6% 9.1% 9.3% 9.4% 9.5% 9.5% 9.5% 9.4% 9.3% 9.2% 9.0%

Inventories 39.8% 39.4% 36.9% 36.1% 35.5% 38.3% 37.0% 37.6% 38.1% 38.4% 38.5% 38.4% 38.2% 37.8% 37.2% 36.6%

Other Current Assets 1.3% 1.1% 1.2% 1.0% 1.2% 1.8% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.2%

PPE and Intangibles, Net 48.3% 49.2% 46.5% 42.4% 40.8% 42.2% 42.8% 42.5% 42.3% 42.4% 42.8% 43.4% 44.2% 45.2% 46.3% 47.6%

Investments 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Other Long Term Assets 1.8% 1.1% 1.2% 0.9% 1.0% 0.9% 1.0% 1.0% 1.1% 1.1% 1.1% 1.1% 1.1% 1.0% 1.0% 1.0%

Accounts Payable and Accrued Liabilities 19.2% 17.5% 18.6% 20.7% 19.8% 20.0% 20.6% 21.0% 21.3% 21.4% 21.5% 21.4% 21.3% 21.1% 20.8% 20.4%

Other Current Liabilities 13.2% 16.6% 11.3% 10.8% 10.8% 10.7% 11.2% 11.4% 11.6% 11.6% 11.7% 11.7% 11.6% 11.5% 11.3% 11.1%

Notes and LT Debt due 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Other Long Term Liabilities 8.0% 7.0% 7.0% 6.8% 7.8% 8.5% 7.6% 7.7% 7.8% 7.9% 7.9% 7.9% 7.9% 7.8% 7.7% 7.5%

Long Term Debt 0.2% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Total Stockholders' Equity 59.4% 58.8% 62.9% 61.6% 61.6% 60.8% 60.4% 59.9% 59.3% 59.0% 58.9% 59.0% 59.3% 59.7% 60.3% 61.0%

Stock / Stock + Debt 99.7% 99.8% 99.8% 99.8% 99.9% 99.8% 99.8% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Debt to Equity 0.00% 0.3% 0.2% 0.2% 0.2% 0.1% 0.2% 0.2% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

forced zero Notes and LT Debt due/Total Debt 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

10

Valuation with Margin Compression

11

Valuation Without Margin Compression

Walgreen

DCF Inputs

(Dollars in Thousands) Time "0" 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Terminal

Operations Net Income 1,359$ 1,573$ 1,836$ 2,033$ 2,218$ 2,380$ 2,512$ 2,614$ 2,686$ 2,728$ 2,743$ 2,732$

Plus Depr. & Amort. 403 482 476 548 608 667 732 804 882 969 1,063 1,167 Equals Value Line "Cash Flow" 1,763 2,055 2,311 2,582 2,826 3,047 3,244 3,418 3,568 3,697 3,806 3,899

- Change in NWC Increases/(Decreases) (749) (852) 594 (323) (300) (275) (249) (223) (197) (173) (150) (129)

= Cash Flow contributed by operations 1,014 1,203 2,905 2,258 2,526 2,772 2,995 3,195 3,370 3,524 3,656 3,770

CAPEX - Capital Expenditures: all categories (710) (1,016) (1,465) (1,214) (1,256) (1,410) (1,561) (1,730) (1,915) (2,118) (2,341) (2,584)

(1) Equals OCF to Equity (Before Debt Adjs.) 303$ 187$ 1,440$ 1,044$ 1,271$ 1,362$ 1,434$ 1,464$ 1,455$ 1,406$ 1,316$ 1,187$

Leverage Tax Rate for leverage adjustments 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5%

Adjustments

(1) + Increase (decrease) in debt - 2 2 2 1 1 1 1 1 1 1 1

Equals "EFCF" or "FCFE" 303$ 189$ 1,442$ 1,045$ 1,272$ 1,363$ 1,436$ 1,466$ 1,456$ 1,407$ 1,317$ 1,187$

(1) + Interest Expense - - - - - - - - - - - - Equals "FCF" 303$ 187$ 1,440$ 1,044$ 1,271$ 1,362$ 1,434$ 1,464$ 1,455$ 1,406$ 1,316$ 1,187$

"FCF" - Interest Tax Shields - - - - - - - - - - - -

Equals "UFCF" 303$ 187$ 1,440$ 1,044$ 1,271$ 1,362$ 1,434$ 1,464$ 1,455$ 1,406$ 1,316$ 1,187$

(Capital Structure Overview)

Accounting balance sheet (book value)

Net Assets (LT Assets + NWC - Other LT Liab) 8,228$ 8,889$ 9,988$ 10,994$ 11,943$ 12,963$ 14,042$ 15,193$ 16,424$ 17,748$ 19,176$ 20,722$ Total Debt 12$ 14$ 15$ -$ -$ -$ -$ -$ -$ -$ -$ -$

percentage of capital 0.1% 0.2% 0.2% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Total Equity Book Value 8,216$ 8,876$ 9,973$ 10,977$ 11,925$ 12,943$ 14,021$ 15,171$ 16,401$ 17,724$ 19,151$ 20,696$

percentage of capital 99.9% 99.8% 99.8% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Economic balance sheet (intrinsic value - Time 0 based on avg. model price, 1-10 based on flow-to-equity)

Total Market Value 38,549$ 41,086$ 42,521$ 44,435$ 46,274$ 48,150$ 50,085$ 52,125$ 54,317$ 56,713$ 59,366$ 62,335$

Total Debt 12$ 14$ 15$ -$ -$ -$ -$ -$ -$ -$ -$ -$

percentage of market value 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Intrinsic Value of Equity 38,537$ 41,072$ 42,506$ 44,435$ 46,274$ 48,150$ 50,085$ 52,125$ 54,317$ 56,713$ 59,366$ 62,335$

percentage of market value 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Current Valuation Summary as of the beginning of yr. 2005 - Intrinsic Share Price (avg. across models): $37.48

Valuation model used Debt Cost of Capital Calculations: Debt Rates Percent of

Equity $M $ Per Share Principal MV Pre Tax After Tax Tot. Mkt. Cap.

Unlevered value $38,526 $37.47 Long Term Debt 11$ $11 6.0% 3.8% (b) 0.0%

Adjusted Present Value $38,526 $37.47 Notes and LT Debt Due 1$ $1 6.0% 3.8% 0.0%

Flow to Equity $38,562 $37.50 Debt Type 3 0 $0 0.0% 0.0% 0.0%

WACC with FCF $38,524 $37.46 Total Debt 12$ 12$ (a) 0.0%AT-WACC with UFCF $38,535 $37.47 wtd. avg. debt rate 6.0% 3.8%

Average across models $38,537 $37.48 Implicit cost of debt according to CAPM: 4.9% 3.1%

Price deviation across models $1 0.1% Equity Cost of Capital Calculations:

Key Assumptions for the models: Without APV: 0.1% Total Value of Equity 46,438$ ( c) 100.0%

Date of valuation 11/3/2005 Total Market Capitalization As of 0 46,450$ 100.0%

Risk Free Rate: 3.50% Actual Unlevered Debt rates used

Risk Free Rate 3.50% 3.50% 6.0% 3.8%

Equity Market Risk Premium: 7.00% Market Premium 7.00% 7.00%

Beta Debt 0.20

Long term inflation: 2.50% Beta Equity 0.5 0.50

Beta - Adjusted Market Premium 3.50% 3.50% Terminal Growth: 5.00%

Various Costs of Capital

Equity beta: 0.5

R(u) - required return for firm if unlevered 7.00%

No. of shares (diluted): 1,028 R(e) - required return for equity as levered 7.00%

WACC 7.00%

Current Market Price per share: $45.16 AT-WACC 7.00%

(a) Represents 38659 Ending Debt Balance. LT Debt is adjusted for MV @ 1

Rough adjustment for midyear (b) Average tax rate for after tax interest rate adjustment: 37.5%Adjustment to the present: (c) Implied Market Cap equals shares 1,028 times Stock Price of $45.16 $37.48 (Actual vs. avg. model price)

Average valuation at Beg. 2005 $37.48 Check on model's internal consistency:

Increase for passage of time: $39.44 We are checking here to see if the debt level is staying constand in market value terms

2005 EFCF/Share *3/4 $0.14 If growth in MV of Equity is much different from growth in Debt, then firm is changing leverage: only APV model works right.

Approximate value as of Sept. 05 $39.31 unless R(e) and the WACC are adjusted to account for changing leverage

Growth in Market Value of Equity (10 yrs) 4.47% Computed from current intrinsic value and value at terminal

Growth in Debt (10 yrs) -100.00% Computed from balance sheet

Other useful summary stats to think about:

1. Implicit Dividend Yield (EFCF/Market Cap.) 0.5% Captures div yield plus stock repurch

2. Growth in Book Equity 8.8%

Forecast years

Summary

12

Walgreen

DCF Inputs

(Dollars in Thousands) Time "0" 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Terminal

Operations Net Income 1,359$ 1,573$ 1,858$ 2,097$ 2,343$ 2,585$ 2,815$ 3,029$ 3,226$ 3,403$ 3,560$ 3,695$

Plus Depr. & Amort. 403 482 476 548 608 667 732 804 882 969 1,063 1,167 Equals Value Line "Cash Flow" 1,763 2,055 2,334 2,646 2,952 3,252 3,547 3,832 4,108 4,372 4,623 4,863

- Change in NWC Increases/(Decreases) (749) (852) 495 (429) (410) (386) (358) (328) (298) (267) (237) (208)

= Cash Flow contributed by operations 1,014 1,203 2,829 2,216 2,542 2,866 3,188 3,504 3,810 4,105 4,386 4,654

CAPEX - Capital Expenditures: all categories (710) (1,016) (1,438) (1,184) (1,223) (1,375) (1,525) (1,695) (1,880) (2,084) (2,308) (2,553)

(1) Equals OCF to Equity (Before Debt Adjs.) 303$ 187$ 1,391$ 1,032$ 1,319$ 1,491$ 1,663$ 1,809$ 1,930$ 2,021$ 2,078$ 2,101$

Leverage Tax Rate for leverage adjustments 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5% 37.5%

Adjustments

(1) + Increase (decrease) in debt - 2 2 2 2 2 2 2 2 1 1 1

Equals "EFCF" or "FCFE" 303$ 189$ 1,393$ 1,034$ 1,321$ 1,493$ 1,665$ 1,811$ 1,932$ 2,022$ 2,080$ 2,103$

(1) + Interest Expense - - - - - - - - - - - - Equals "FCF" 303$ 187$ 1,391$ 1,032$ 1,319$ 1,491$ 1,663$ 1,809$ 1,930$ 2,021$ 2,078$ 2,101$

"FCF" - Interest Tax Shields - - - - - - - - - - - -

Equals "UFCF" 303$ 187$ 1,391$ 1,032$ 1,319$ 1,491$ 1,663$ 1,809$ 1,930$ 2,021$ 2,078$ 2,101$

(Capital Structure Overview)

Accounting balance sheet (book value)

Net Assets (LT Assets + NWC - Other LT Liab) 8,228$ 8,889$ 10,060$ 11,143$ 12,169$ 13,266$ 14,419$ 15,641$ 16,938$ 18,322$ 19,805$ 21,400$ Total Debt 12$ 14$ 15$ -$ -$ -$ -$ -$ -$ -$ -$ -$

percentage of capital 0.1% 0.2% 0.2% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Total Equity Book Value 8,216$ 8,876$ 10,044$ 11,125$ 12,150$ 13,245$ 14,396$ 15,616$ 16,911$ 18,294$ 19,776$ 21,369$

percentage of capital 99.9% 99.8% 99.8% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Economic balance sheet (intrinsic value - Time 0 based on avg. model price, 1-10 based on flow-to-equity)

Total Market Value 63,254$ 67,525$ 70,860$ 74,770$ 78,683$ 82,699$ 86,823$ 91,089$ 95,534$ 100,199$ 105,134$ 110,390$

Total Debt 12$ 14$ 15$ -$ -$ -$ -$ -$ -$ -$ -$ -$

percentage of market value 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Intrinsic Value of Equity 63,242$ 67,512$ 70,845$ 74,770$ 78,683$ 82,699$ 86,823$ 91,089$ 95,534$ 100,199$ 105,134$ 110,390$

percentage of market value 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Current Valuation Summary as of the beginning of yr. 2005 - Intrinsic Share Price (avg. across models): $61.50

Valuation model used Debt Cost of Capital Calculations: Debt Rates Percent of

Equity $M $ Per Share Principal MV Pre Tax After Tax Tot. Mkt. Cap.

Unlevered value $63,228 $61.49 Long Term Debt 11$ $11 6.0% 3.8% (b) 0.0%

Adjusted Present Value $63,228 $61.49 Notes and LT Debt Due 1$ $1 6.0% 3.8% 0.0%

Flow to Equity $63,271 $61.53 Debt Type 3 0 $0 0.0% 0.0% 0.0%

WACC with FCF $63,225 $61.49 Total Debt 12$ 12$ (a) 0.0%AT-WACC with UFCF $63,244 $61.50 wtd. avg. debt rate 6.0% 3.8%

Average across models $63,242 $61.50 Implicit cost of debt according to CAPM: 4.9% 3.1%

Price deviation across models $1 0.1% Equity Cost of Capital Calculations:

Key Assumptions for the models: Without APV: 0.1% Total Value of Equity 46,438$ ( c) 100.0%

Date of valuation 10/31/2005 Total Market Capitalization As of 0 46,450$ 100.0%

Risk Free Rate: 3.50% Actual Unlevered Debt rates used

Risk Free Rate 3.50% 3.50% 6.0% 3.8%

Equity Market Risk Premium: 7.00% Market Premium 7.00% 7.00%

Beta Debt 0.20

Long term inflation: 2.50% Beta Equity 0.5 0.50

Beta - Adjusted Market Premium 3.50% 3.50% Terminal Growth: 5.00%

Various Costs of Capital

Equity beta: 0.5

R(u) - required return for firm if unlevered 7.00%

No. of shares (diluted): 1,028 R(e) - required return for equity as levered 7.00%

WACC 7.00%

Current Market Price per share: $45.16 AT-WACC 7.00%

(a) Represents 38656 Ending Debt Balance. LT Debt is adjusted for MV @ 1

Rough adjustment for midyear (b) Average tax rate for after tax interest rate adjustment: 37.5%Adjustment to the present: (c) Implied Market Cap equals shares 1,028 times Stock Price of $45.16 $61.50 (Actual vs. avg. model price)

Average valuation at Beg. 2005 $61.50 Check on model's internal consistency:

Increase for passage of time: $64.73 We are checking here to see if the debt level is staying constand in market value terms

2005 EFCF/Share *3/4 $0.14 If growth in MV of Equity is much different from growth in Debt, then firm is changing leverage: only APV model works right.

Approximate value as of Sept. 05 $64.59 unless R(e) and the WACC are adjusted to account for changing leverage

Growth in Market Value of Equity (10 yrs) 5.19% Computed from current intrinsic value and value at terminal

Growth in Debt (10 yrs) -100.00% Computed from balance sheet

Other useful summary stats to think about:

1. Implicit Dividend Yield (EFCF/Market Cap.) 0.3% Captures div yield plus stock repurch

2. Growth in Book Equity 9.2%

Forecast years

Summary