Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition

CHAPTER 9

Measuring Earnings

To estimate cash flows, we usually begin with a measure of earnings. Free cash flows to the firm, for instance, are based on after-tax operating earnings. Free cash flows to equity estimates, on the other hand, commence with net income. While we obtain measures of operating and net income from accounting statements, the accounting earnings for many firms bear little or no resemblance to the true earnings of the firm.

This chapter begins by considering the philosophical difference between the accounting and financial views of firms. We then consider how the earnings of a firm, at least as measured by accountants, have to be adjusted to get a measure of earnings that is more appropriate for valuation. In particular, we examine how to treat operating lease expenses, which we argue are really financial expenses, and research and development expenses, which we consider to be capital expenses. The adjustments affect not only our measures of earnings but our estimates of book value of capital. We also look at extraordinary items (both income and expenses) and one-time charges, the use of which has expanded significantly in recent years as firms have shifted toward managing earnings more aggressively. The techniques used to smooth earnings over periods and beat analyst estimates can skew reported earnings, and, if we are not careful, the values that emerge from them.

ACCOUNTING VERSUS FINANCIAL BALANCE SHEETS

When analyzing a firm, what are the questions ...