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

MULTIPLES-BASED VALUATION

Valuation based on industry multiples boils down a complex function of discount rates and future cash flows into a simple proportional relationship: Predicted value equals the level of the value driver for that company times the corresponding industry multiple. Because the industry multiple is an “average” ratio of stock price to value driver for the remaining companies in the industry, predicted values based on multiples will be close to traded stock prices if companies in the industry are relatively similar in terms of the price-to-value-driver ratio. That is, our research question can be viewed intuitively as follows: Are companies within an industry more homogeneous in terms of P/Es or price-to-cash-flow ratios (P/CFs)? Stated differently, if we plotted histograms of the P/Es and P/CFs in an industry, the value driver with the tighter distribution should result in better valuations because a tighter distribution indicates that companies’ ratios are closer to each other and, therefore, closer to the industry average. However, although comparing the tightness of such distributions would allow us to rank earnings versus cash flows in each industry, it would not quantify the extent to which valuations from earnings and valuations from cash flow multiples deviate from traded stock prices. The methodology that allows us to do that is described next.

For each value driver, we first calculated an industry multiple for each company based on the prices and value ...