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

NOTES

1. The adage that “you manage what you measure” applies to cash earnings and cash flows as much as it does to accounting net income. Managing cash flow is as simple as delaying the payment of a supplier or running an advertising campaign a week earlier or later.

2. Although finance and accounting researchers have performed innumerable studies modeling and testing the relationship between earnings and stock returns and between earnings and stock values, the discussion in this section focuses on the most important lessons to be learned from a handful of the studies. For a more complete synthesis of research investigating the value relevance of earnings and other types of accounting information, see Bernard (1989), Lev (1989), Lev and Ohlson (1982), and Bauman (1996).

3. Ball and Brown used three proxies for unexpected earnings, with similar results for each. We limit our discussion to the random walk change in earnings or, more simply, the change in earnings from one year to the next. Ball and Brown also analyzed the abnormal returns on each company’s stock. “Abnormal return” was defined as a company’s common stock return for a month adjusted for the expected return as predicted by the capital asset pricing model (CAPM).

4. The residual change in earnings measure used in Beaver et al. was a proxy for companies’ unexpected earnings, and the residual change in price represents companies’ common stock return for a month adjusted for the expected return as suggested by the CAPM. ...