Date of Award
Master of Valuation Science
Business valuation texts and reference sources all seem to indicate that the rate of return on cash flow should be between 300 and 600 basis points lower than the rate of return for earnings. Thus, when using a build-up approach to determine the rate of return on cash flow, an addition of between 3 percent and 6 percent is necessary to arrive at a rate of return on earnings. This thesis analyzes the relationship between earnings and cash flow (as dividends) over a two year period from 1993 to 1994.
The purpose of this study was to study the relationship between earnings and cash flow based on a number of criteria including the size of the company, its historical sales growth, its return on equity, and its capital structure. Hopefully, the conclusions reached in this paper will provide business appraisers with a reliable source on which to base adjustments to discount and capitalization rates when using the net cash flow or earnings approaches.
My empirical study was based on an analysis of over 2,000 publicly-traded companies during both years of the analysis. I looked at a number of performance and descriptive criteria of each company to determine its impact, if any, on the relationship between earnings and cash flow. Over the two years analyzed, the differential between earnings yield and dividend yield averaged 5.29%, supporting the 3% to 6% "rule of thumb" used by many business valuation practitioners.
The size of the subject company, the nature of the industry in which it operates, the company's return on equity, and the company's leverage all impacted the relationship between the earnings yield and the dividend yield of the company. In particular, the relationship between the size of the company and the yield differential was very strong, showing a 0.95 R2 correlation over the two year period. Large companies (market capitalization over $3 billion) had an average yield differential of about 3% while small companies (market capitalization less than $20 million) had an average yield differential of over 7%. The study indicates that an adjustment to the cash flow discount rate of greater than 6 percent may be warranted in the valuations of many small. closely-held businesses. Of course, the business appraiser should carefully analyze the nature of the company, the economic environment in which it operates, and other factors which could impact the current and future relationship between earnings and cash flow.
Agiato, Joseph A., "Empirical Research Study of Rates of Return on Earnings and Cash Flow" (1995). Theses. 437.
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