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

EQUITY VALUATION IN PERSPECTIVE

Unlike rare art, stocks are presumed to have an intrinsic value. The intrinsic value of a Van Gogh painting is ill defined; basically, it is the amount that someone is willing to pay for it. But when equity analysts think of valuation, we think of intrinsic value. We have in mind a monetary sum that corresponds to the present value (PV) of expected future payoffs to shareholders. Equity valuation methods differ in technique, but they share the same objective—to estimate the PV of these payoffs to shareholders.

An obvious observation that follows directly from this definition is that equity valuation involves forecasting. Estimates of future cash flows, discount rates, and option values all involve forecasting what could happen to a company in the future. Some techniques, such as multiple-based approaches, may not appear to involve forecasting. In using these types of techniques, however, the analyst is taking a shortcut with the ultimate goal of forecasting a company’s future prospects. In fact, it is probably useful for us to acknowledge from the outset that equity valuation is an imprecise science. It involves an educated guess, whereby analysts peer into an uncertain future and attempt to predict what a company might be worth.

No More New Economy

What about the “new economy”? We do not hear the term used much anymore. Only a few years ago, many were ready to discard traditional valuation models because the models failed to rationalize the successively ...