Determinants
In the introduction to discounted cash flow valuation, we
observed that the value of a firm is a function of three
variables—itscapacityto generatecash flows,its expected
growth in thesecash flows,and the uncertaintyassociated
with these cash flows. Every multiple, whether it is of
earnings,revenues,orbookvalue,isafunctionofthesame
three variables—risk, growth, and cash-flow-generating
potential. Intuitively, then,firms with highergrowth rates,
less risk,and greater cash-flow-generating potential should
tradeathighermultiplesthanfirmswithlowergrowth,higher
risk, and less cash flow potential.
The specific measures of growth, risk, and
cash-flow-generatingpotential thatareusedwill varyfrom
multipletomultiple.Tolookunderthehood,sotospeak,of
equity and firmvalue multiples,we cango backto fairly
simplediscountedcashflowmodelsforequityandfirmvalue
and use them to derive the multiples.
Inthesimplestdiscountedcashflowmodelforequity,which
is a stable-growth dividend discount model, the value of
equity is:
whereDPS 1 istheexpecteddividendinthenextyear,keis
thecostofequity,andgnistheexpectedstablegrowthrate.
Dividingbothsidesbytheearnings,weobtainthediscounted
cash flow equation specifying the P/E ratio for a stable
growth firm.