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

CONCLUSION

This research project began with the goal of providing analysts with the answer to the question “What are earnings?” One might think that answering this question would be fairly straightforward for two accounting professors. As we considered ways to formulate our answer, however, we quickly realized how big this question actually is. In the United States, academic accounting scholars have spent the better part of the 20th century trying to answer this question, and this quest has generated some wonderful insights about the definition and measurement of “true” economic earnings—from the academic’s philosophical perspective. Little of this research, however, could directly benefit a practicing equity analyst in answering our initial question. Because equity analysts are, first and foremost, concerned with valuation, our primary goal in writing this chapter was to demystify reported earnings and to explain how they can best be incorporated into valuation activities.

In the section “Evidence on the Relevance of Earnings to Valuation,” we provided selected highlights from the large body of academic research that demonstrate the relevance of accounting information to security prices. This body of research documents the importance not only of the bottom-line net income figure but also of components of earnings. If the goal is to forecast future free cash flows, current accounting earnings actually are more helpful than current-period cash flows. The bulk of prior research, ...