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

QUESTION AND ANSWER SESSION

Question: Why do you exclude changes in working capital from your calculation?

Ohlson: It is not excluded! Remember that I am working backward, so to speak, from the entire balance sheet. Remember also that debits equal credits; thus, the change in invested capital from a financial perspective must, by construction, equal the change in invested capital from an operating perspective. One can use either approach, of course. The number will always be the same as long as we are comprehensive and mutually exclusive in the treatment of the line items in the balance sheet.

Question: How can the FCF approach be applied to a rapidly growing small company that is generating negative cash or to a company that is acquisition driven?

Ohlson: It cannot be applied very well in the case of rapid growth and negative cash. Whenever we try to value a company that has a growth factor in excess of the discount factor, we will have very difficult problems, because no growth rate can exceed the discount factor forever. Somewhere along the line, we have to make a call as to when that growth rate is going to level off, decline, and ultimately go below the discount factor. Even this approach to the growth problem does not completely solve the problem of how to value a currently negative cash generator. This kind of case always poses daunting valuation problems.

An acquisition-driven company poses similar problems: If I believe that acquisitions are going to change a company’s ...