The Dynamics of Performance Volatility and Firm Valuation

Abstract

We construct a model to illustrate the dynamics of cash flow volatility and firm valuation. As a firm progressively invests into its growth opportunities, its book value increases and catches up with its market value, reducing the valuation multiple (Q). Cash flow volatility (CFV) decreases due to the diversification effect of investing into more market segments. We document a positive CFV-Q association, which varies with firm size, investment opportunities, and the correlation across market segments. Empirical findings strongly support the model predictions and are robust to alternative explanations offered by extant studies on firm growth, volatility, and valuation.

Keywords: cash flow volatility, firm valuation, growth, firm size, firm age, Tobin's Q

JEL Classification: G30, G31