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

NOTES

1. For example, valuation performance could be measured, based on the argument that over- (under-) valued stocks will have relatively high (low) P/Es, as the returns earned by a strategy that invests short (long) in stocks with P/Es that are higher (lower) than the industry median.

2. Baker and Ruback (1999) demonstrated that the magnitude of pricing errors tends to increase with price and thus the harmonic mean is a better estimator of the industry multiple than such estimators as the arithmetic mean or median. As demonstrated in the example in the text, the harmonic mean gives less weight to companies with relatively high price-to-value-driver ratios, which is consistent with the larger absolute valuation errors that typify these companies. Indeed, several studies (e.g., Beatty, Riffe, and Thompson 1999; Liu et al. 2002) confirmed that the harmonic mean performs well in terms of minimizing price-deflated pricing errors.

3. Although analysts also provide one-year-out (for 1990) forecasts, we elected not to use them because they represent a mixture of actuals for interim periods already reported and forecasts for the remaining interim periods.

4. I/B/E/S uses a proprietary classification scheme to categorize companies into homogeneous groups according to business lines. In the United States, a scheme similar to the S&P 500 Index industry groupings is followed. For non-U.S. companies, a system based loosely on the Morgan Stanley Capital International industry classifications ...