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

VALUATION MODELS: TRADITIONAL VERSUS REAL OPTIONS

The valuation of an investment opportunity normally focuses on a series of future cash flows that are expected from this opportunity. The typical process of evaluating an investment opportunity involves estimating future cash flows, discounting these cash flows to the present at a rate that reflects the risk of the project, and comparing this discounted value of these cash flows with the required investment outlay. If the investment is expected to create value—that is, the present value of these future cash flows exceeds the investment outlay—the project is desirable; otherwise, the company will not make the investment.

When managers estimate what it costs to invest in a given project and what its benefits will be in the future, they are coping with uncertainty. The uncertainty arises from different sources, depending on the type of investment being considered, as well as the circumstances and the industry in which it is operating. Uncertainty can result from economic factors, market conditions, taxes, and interest rates, among many other sources.

These sources of uncertainty influence future cash flows. Thus, managers need to assess the uncertainty associated with a project’s cash flows in order to select value-adding projects. One of the challenges in evaluating an investment opportunity is capturing the flexibility options that a project offers. An approach to dealing with these flexibility options is to use traditional methods ...