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

NOTES

1. EVA and MVA are trademarks of Stern, Stewart & Company.

2. See, for example, the evidence produced in Healy (1985) and Holthausen, Larcker, and Sloan (1995).

3. The link between pay and performance is highlighted in the BusinessWeek special report by Byrne and Bongiomo (1995).

4. The key elements of the cost of capital concept in capital budgeting are that (1) the cost is a marginal cost (the cost on the next dollar of capital) and (2) the cost reflects the risk of the individual project. For a more detailed presentation of the cost of capital, see Appendix 3A.

5. This article is a continuation of their work in Leibowitz and Kogelman (1990); see also Leibowitz and Kogelman (1994).

6. A detailed description of the value-added methods can be found in Stewart (1991).

7. Another prominent valuation approach is the discounted-cash-flow approach advocated by McKinsey & Company and discussed by Copeland, Koller, and Murrin (1994, p. 116). This approach involves forecasting future periods’ free cash flows, forecasting a firm’s continuing value at the end of the forecast period, and discounting the future free cash flows and the continuing value at the firm’s weighted-average cost of capital. Because this approach involves valuation based on forecasts, it is not a suitable device for evaluating performance, although it is useful in setting performance targets.

8. The decomposition of return ratios in terms of profit margin and turnover ratios is credited to E.I. duPont de Nemours ...