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

DECOMPOSING EARNINGS

The idea of earnings decomposition comes directly from the 1934 edition of Benjamin Graham and David Dodd’s Security Analysis. Broadly, earnings can be decomposed into the change in book value (retained earnings) plus the dividend, which I define broadly as the sum of cash dividends, including any cash paid out for stock repurchases and less any cash brought in through a capital transaction, such as a secondary equity offering.

The change in the book value can be further broken down. Remember that the change in book value is equal to the change in assets less the change in liabilities—or the change in NOA (accruals) plus the change in cash holdings less the change in debt. As a result, earnings can be decomposed into the change in NOA (accruals) plus FCF. The result is two pieces to earnings: a hard piece, the FCF, and a soft piece, the change in NOA, which as shown earlier results from the accounting assumptions made (this is also the area where the accounting envelope tends to be pushed). Thus, I look at the aggregate magnitude of the accruals, the change in NOA, to evaluate the quality of earnings.

More specifically, my rule of thumb is that if the change in NOA divided by the average level of NOA exceeds 5 percent, a red flag goes up. Enron Corporation and WorldCom were way above 5 percent for the two years before their situation became public knowledge. This simple metric would have picked up both of them.

To further demonstrate the usefulness of this ...