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

NOTES

1. For convenience, I refer to the valuation of existing shares as equity valuation. Options are also equity instruments, but I focus on existing shareholders, reflecting the perspective of an investor assessing the implicit value of outstanding shares.

2. Conceptually, an alternate approach would be to assume no future option grants in valuing the existing equity under the assumption that future grants total zero in net present value. But given that the historical data (such as sales growth rates and profitability) reflect the effects of options, fully purging their impact on cash flow forecasts is difficult. At a minimum, some assumption would be required for how much nonoption compensation would substitute for the value of options sacrificed by employees. Furthermore, to the extent that the effect of option compensation is not zero in net present value, ignoring option costs and benefits will misvalue existing equity. As a consequence, explicitly building option forecasts into equity valuation is probably preferable.

3. For convenience, I refer to the accounting issue as relating to whether options should be expensed. But the issue is not primarily about expensing options per se (because current accounting requires that the intrinsic value of options be expensed) but, rather, about how the expense should be measured and whether it should reflect the fair value of option compensation (computed based on an option-pricing model such as Black–Scholes).

4. The full text of ...