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

EVIDENCE ON THE RELEVANCE OF EARNINGS TO VALUATION

In this section, we consider the empirical evidence for three aspects of the relevance of accounting earnings to valuation: the relationship between earnings data and stock prices, the information content of earnings data relative to the information content of cash flow data, and the use analysts make of earnings data in valuation.

In truth, a formal study of the role of accounting earnings in the capital markets is not needed to gauge the importance of reported income in the work of managers, analysts, and investors. Articles in the business press clearly focus significant attention on companies’ quarterly and annual earnings announcements. Furthermore, corporate managers go to great lengths to explain the factors that influence reported income numbers and, increasingly, try to manage analysts’ earnings expectations. For example, in recent years, the incidence of managers “talking down” investors’ earnings expectations in the weeks leading up to an earnings announcement has increased. Their methods include initiating “whisper forecasts” and “preannouncing” earnings. In addition, the business press regularly provides comprehensive analyses of corporate valuations in terms of earnings-based multiples (e.g., the price-to-earnings ratio). Even articles announcing quarterly results for Internet companies include numerous adjustments and qualifications intended to guide the investing public to some estimate of (distant) future earnings. ...