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

INTRODUCTION

Many textbook explanations of equity security valuation provide students and analysts with clear and concise explanations that give a false impression of the practical complexity of the valuation exercise. Part art and part science, part dissecting the past and part predicting the future—valuation is simultaneously a rewarding and frustrating process. On the one hand, gathering relevant information from a variety of sources and distilling it into a range of reasonable equity values is rewarding. It is the cornerstone of many individual and institutional investors’ decisions to buy, sell, or hold securities. On the other hand, valuation is frustrating because it is fraught with uncertainty. First is the uncertainty associated with the exercise itself (for example, what is the right valuation model to use? Is the price too high? When will the market share my beliefs about the future and correct the price?). In addition, analysts find themselves playing cat-and-mouse games with the preparers of corporate financial statements. That analysts cannot simply take information reported in financial statements at face value is an aspect of equity valuation that significantly increases the complexity of an already difficult activity.

The rules that guide the preparation of financial statements in the United States (generally accepted accounting principles, or GAAP) allow company managers sufficient latitude to effectively communicate the financial position and results of the company ...