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

INTRODUCTION

Valuation is the cornerstone for the edifice we call “security analysis.” The pioneering work in developing a rigorous theory for valuation was published in 1938 as The Theory of Investment Value by John Burr Williams. For reasons that I have never been able to understand, it was not until 1959, when Myron J. Gordon published his paper “Dividends, Earnings, and Stock Prices” in the Review of Economics and Statistics (where the now well-known Gordon model was put forth), that attention was finally directed to the seminal work of Williams’s 1938 piece. Perhaps it was the highly quantitative nature (for its time) of the original Williams work that deterred earlier interest; after all, in the early days finance and investments were largely descriptive fields of endeavor and devoid of quantitative analysis other than that related to accounting statements. Benjamin Graham and David Dodd published their first edition of Security Analysis in 1934, and the valuation work in that text was accounting based and did not contain the necessary theoretical underpinnings that Williams and then Gordon later developed. Security Analysis (ultimately six editions have been published) was considered the definitive work for investors until the late 1960s, when attention began to turn to more advanced methodologies that were consistent with an understanding of the theory of valuation. Graham himself was somewhat skeptical of Williams’s valuation theory, saying in his 1939 review (Journal ...