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

PROBLEMS WITH EARNINGS FOCUS

Have analysts or investors solved their problems by moving from FCFs to earnings? Certainly not. In general, earnings realizations depend substantially on generally accepted accounting principles (GAAP), and companies have discretion and can manage their earnings by using their choice of accounting principles. Perhaps more importantly, they can also manage transactions within the context of GAAP. Investors might suspect, then, that accounting numbers generally, and earnings numbers specifically, are not really indicative of the company’s performance. Ultimately, investors are left with the quality of earnings issue, which commingles two tricky factors: (1) the company’s real economic activities and the creation of value and (2) the company’s application of accounting principles and management of transactions.

The general idea is to determine whether the current earnings are a good indicator of earnings in the future. The company does not even have to be acting mischievously to cause distortions; circumstances may simply create a high quality of earnings or a low quality of earnings. Even under fairly ideal circumstances, determining whether current earnings are, in fact, closely aligned with future earnings is difficult. To the extent that EPS mirrors economic reality, this similarity is often more by chance than by construction. Some telling examples of the difficulties of earnings assessment can be seen in a variety of accounting principle applications ...