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

EARNINGS MEASURES AND VALUATION

The dispute about earnings quality arises because of two conflicting interpretations of the motives underlying company releases of their own pro forma income numbers in addition to U.S. GAAP numbers. The first view, expressed succinctly by various spokespersons for online supermarket Amazon. com, is that appropriate pro forma results give better insight into the fundamental operations of a business than does the bottom line. Thus, according to Amazon, pro forma numbers provide investors with more accurate guidance as to the company’s future earnings and cash flow. The second view, voiced by various past and current SEC officials, including Turner (2000), is that the presentation of differing earnings measures is an effort to present a company’s financials in an artificially favorable light. In fact, Turner has cynically referred to many pro forma releases as “EBS accounting,” in that they include “everything but bad stuff.”

This dispute is highlighted by Amazon’s own chosen pro forma measure. As Bradshaw and Sloan (2002) pointed out, Amazon chooses to report pro forma earnings that exclude amortization of goodwill and other intangibles, equity in losses of companies not consolidated, stock-based compensation costs, merger and acquisition costs, investment-related costs, and interest expense on long-term debt. But despite excluding equity-method losses, Amazon includes revenue associated with noncash transactions in which the company received equity ...