Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CHAPTER 17

ACCOUNTING VALUATION: IS EARNINGS QUALITY AN ISSUE?a

Bradford Cornell and Wayne R. Landsman

Debate has raged for decades about which valuation methodology is the best for valuing a business interest. In practice, companies often prefer to present pro forma measures of value instead of the results from using measures established by accounting authorities and regulators. In this article, the authors argue that there is essentially no difference between various valuation methodologies if they are accurately and consistently applied. However, this is true only as long as those who use pro forma earnings numbers provide transparency about how pro forma numbers differ from traditional accounting earnings numbers and as long as they apply these differing methods consistently. Essentially, the argument is that the best earnings method is the one that makes the most sense to the analyst’s view of the business under study, which can be considered license to apply careful judgment, rather than blind methodology, in valuing a business interest.

Two forces have combined to focus increasing attention on the issue of the quality of reported corporate earnings. On the one hand, a growing number of companies are including pro forma earnings as well as net income figures in their earnings releases. The explanation is that pro forma numbers reflect the company’s true earning power more accurately than does net income.1 Analysts have echoed the company support for these “Street” estimates ...