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

SCREENING

The first potential use for these traditional valuation methods is to look for ways of narrowing the overwhelmingly large universe of investable companies down to some number of reasonable candidates that are more likely to have the desired value characteristics. This process is called screening.

Numerous studies have been done on all of the traditional valuation models, with a variety of results. Researchers contend that if portfolio managers would only follow a particular valuation model, such as low P/E, P/S, or P/B, they would be rewarded with outperformance. In fact, studies have shown that applying any one of these methods blindly and faithfully will generate outperformance over time; however, many practical reasons can be found for not applying these methods blindly and faithfully. Perhaps the most important is that such quantitatively generated portfolios typically exhibit other characteristics that may not be prudent for most investors. So, although screening is useful for identifying potential investment candidates, analysts must take care to understand the implications of the screening factor for portfolio construction.

To illustrate the biases of the traditional valuation methods, I put about 1,000 of the largest companies in the United States through five valuation screens: P/B, P/S, P/E, P/E to growth (a form of P/E valuation), and the DDM. I created five model portfolios, each consisting of the 50 cheapest stocks as defined by the particular valuation method. ...