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

INTRODUCTION

Analyzing the investment potential of a publicly traded company is a challenging task. An analyst assembles a vast amount of information from a variety of sources, carefully avoiding inappropriate nonpublic information and ignoring information in the form of rumor rather than fact. Standard discounted cash flow (DCF) techniques are commonly applied to estimated future cash flows, leading to an overall assessed value of the company. The analyst must often probe not only the finances of a company but also the more subtle possibilities that a company may have for creating wealth, which is where the task gets really difficult. A good analyst uncovers the hidden value in a company. That hidden value may emanate from a variety of sources, but rarely, if ever, will it be easy to detect. Perhaps the difficulty in uncovering hidden value is fortunate, for if it were easy to detect, then in all likelihood, it would already be built into the current market value. And detecting that hidden value before everyone else is what good analysis is all about.

Although investment analysts rarely delve into the micro level of analyzing specific projects of companies, they must understand how companies themselves value their own investment projects. Some companies make value-enhancing capital investments; others make poor capital investments. Understanding how companies make capital investments is important to an investment analyst looking at a company as an outsider.

The DCF approach to ...