Cash Flow Multipliers and Optimal Investment Decisions

Abstract:     
Valuation multipliers are frequently used in practice. We analyze the multiplier that yields the value of the firm when multiplied by the current cash flows of the firm, i.e. the cash flow multiplier. By postulating a simple stochastic process for the firm's cash flows in which the drift and the variance of the process depend on the investment policy, we develop a stylized model that links the cash flow multiplier to the optimal investment policy. Our model implies that the multiplier increases with investment at a decreasing rate (diminishing marginal returns on capital), i.e. there is a nonlinear relationship between the multiplier and investment. On the other hand, the multiplier is inversely related to discount rates. Using an extensive data set we examine the implications of our model. We find strong support for the variables postulated by the model.

Number of Pages in PDF File: 33

Keywords: Firm valuation, Valuation multiples, Real options

JEL Classification: G12

working papers series