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

SHORTCUTS

How are analysts to solve the daunting problem of determining which companies and stocks have value? So much data and information are available. The world is very complicated, and shortcuts are not only helpful but also nearly mandatory. These shortcuts can be categorized into two groups: expectational models and valuation models.

Expectational Models

The focus in expectational models is typically the so-called momentum measures: earnings surprise, earnings revisions, or other technical measures. These models assume that the trend that is in place will stay in place. In the case of earnings surprise, for instance, it is not the existence of the last earnings surprise that will provide outperformance. Rather, it is the fact that the last earnings surprise is a good predictor that another earnings surprise will occur. By definition, nobody expects that next earning surprise because the market efficiently adjusts its expectations. But much of the time, expectations are not adjusted enough. So, in an expectational model, a company keeps reporting positive earnings surprises, and the analysts keep raising earnings estimates until the company hits the wall and announces significantly disappointing news. Then, all the expectation-oriented investors sell the stock, and the stock’s price goes down some large percentage in one day.

Valuation Models

Valuation models are typically based on mean-reversion, or contrarian, approaches. They assume that the trend that is in place will ...