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

SUMMARY AND CONCLUSIONS

The financial analysis of a company is a difficult undertaking, even under the best of circumstances. Financial information is never completely sufficient to uncover the hidden benefits and costs that distinguish one company from another. Even when information is easy to obtain, the analytical techniques often rely on heroic assumptions and forecasts about growth rates, dividend policy, capital expenditures, and a host of other factors that are difficult to predict. Further complicating the process of financial analysis is the fact that many, if not all, companies have some opportunities that are not so apparent. These opportunities are in the form of options that give a company flexibility in making decisions. Companies can terminate projects, switch to alternatives, enter new markets, exit old markets, delay expansions, and expand or contract existing investments. Standard accounting principles do not allow the value of such opportunities to appear on balance sheets, and the gains and losses from changes in the value of these opportunities are never recorded in earnings. Unquestionably, these opportunities are a source of value, but as noted, they are difficult to detect. In fact, we can probably safely say that many companies themselves are unaware of many of these valuable opportunities that they possess.

These opportunities are called real options, named as such because they deal with opportunities related to real investments, as opposed to financial ...