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

FOREWORD

From peak to trough, Enron’s share price declined 99.98%, or from around $90 per share to just $0.02, in only 12 months. Near its pinnacle valuation, rallying cries could be heard from the company’s management that Enron’s already inflated stock price was sure to go even higher. Unfortunately, most investors and analysts followed the tune of the Enron piper, paying no heed to the company’s true state when close scrutiny might have revealed hidden cracks in its foundation. Too few analysts questioned Enron’s valuation, and those who did were often met with derision from employers, peers, and even Enron’s management. Groupthink pervaded Enron’s valuation, and investors and employees paid dearly.

How was Enron’s fraud eventually uncovered? Daniel Scotto, an analyst at BNP Paribas, was one of the first investment professionals to sound the alarm bells. After conducting a thorough analysis of Enron that included an estimation of its value, Scotto said Enron securities “should be sold at all costs and sold now” in a 2001 research report. As has been the case so often in the capital markets, valuation proved to be an essential investment tool to point toward fraud.

Reporting shortly after the Enron scandal broke, Rebecca Smith, in her article headlined “Ex-Analyst at BNP Paribas Warned His Clients in August about Enron” in the 29 January 2002 edition of the Wall Street Journal, stated:

Mr. Scotto’s experience highlights one of the oldest pressure points on Wall Street involving ...