Questions about Valuation and Corporate Finance
Hello I'm a student interested in investment banking field and I have some questions to ask you 1. In Gordon growth model, why r has to be less than g? what's the intuitive reason, not from the equation. 2. In which case that firm can have high cash flow but low profit, what's their rationale ? 3. I have heard that some multiples that give more stable value is better than other that give more volatile value, I'm confused that why the more volatile value (means multiple change as value changes) is not good?
Thank you
1) r needs to be higher than g 2) the difference is linked to non-cash items (ex. working capital moves, D&A) 3) if you are valuing a company you don't want that value to change dramatically everyday
1) Think about it this way: for the terminal value, you are trying to measure what the company's cash flow is worth into eternity. It is practically impossible to have a higher growth rate than discount rate, because a company with an eternal growth rate of >10 % (which is what you would often use as the rate of return in basic corp fin classes) would essentially "take over the world" further down the road. Ie. your company will have infinite value.
2) Are you asking about high cash flow or high net working capital? If it's the former; A company that has low margins can produce large free cash flows, but the net income will be low due to the nature of their business. Typical low margin sectors could be food chains such as Walmart and Target, or utility companies.
3) Multiples such as EV/EBITDA are more stable because they don't include taxes, interest, depreciation or amortization. If you have to write down the value of a property or plant one year this could change your earnings quite a lot, whereas the EBITDA stays the same. Looking at the EV/EBITDA should, therefore, give a more "realistic" look into what the company should be trading at compared to the P/E.
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