Joe Watts, an analyst at EMH Securities, states: "I don't know why anyone would ever try to value earnings. Obviously, the market knows that earnings can be manipulated and only values cash flows.". Discuss

Answer 1

Valuing earnings is an alternative way of valuing a company even if earnings can be manipulated. Note that, with an infinite forecast horizon, the valuation based on discounted abnormal earnings delivers exactly the same estimate as DCF-based methods, even if there is earnings manipulation. The estimated values using accounting-based valuation are not affected by accounting choices because of the self-correcting nature of double-entry bookkeeping. Current period earnings can be manipulated, but the values estimated with accounting-based valuation are not to be manipulated. However, with finite horizons, earnings manipulation can affect value unless the analyst recognizes and undoes the manipulation. Also, when accounting data is used to forecast cash flows, even a DCF valuation is potentially vulnerable to accounting manipulation.
There are two practical advantages to valuing earnings. First, accounting-based valuation (using earnings) frames the valuation task differently and can immediately focus the analyst's attention on the key measure of performance: ROE and its components (i.e., value drivers such as profit margins, sales turnover, and leverage).
Second, if it is more natural to think about future performance in terms of accounting returns, and if the analyst faces a context where a "back-of-envelope" estimate of value would be of use, the accounting-based technique can be simplified to deliver such an estimate. "Shortcut" estimates are useful in a variety of contexts where the cost and time involved in a detailed DCF analysis is not justified. In this context, the detailed DCF method is analogous to a manual camera for which the distance, light exposure, and shutter speed need to be set before taking a picture whereas the "shortcut" accounting-based valuation is analogous to an automatic camera.