An e-question during BVR's teleconference on Goodwill Impairment in a Troubled Economy dealt with the interaction of discount rates and cash flow forecasts. “When the first five years [of cash flow projections] are negative,” the attendee asked, “how might this affect your discount rates and debt-equity ratio? Would they then vary from one year to the next? Consider that applying a higher discount rate to negative cash flows results in a lower negative present value amount.”
“There’s a fairly good argument as to why that makes sense,” commented Edward Morris Jr. (Clifton Gunderson, LLP). “For different points in time and considering the company’s projections going forward, there will be different risks in the marketplace. The risk may be higher particularly for the negative years.” There could very well be different cost of capital calculations and ratios done on an annual basis for a period of time until you reach what you consider a stable “go-forward” earnings in cash flow.
“There is also the ‘H Model',” said moderator Jim Alerding (Clifton Gunderson), “which says if you have discrete periods of time where you do have different impacts on your cash flows for either business or economic reasons, that you stage your rates and perhaps your ratios of debt to equity.” Where can you find more information? Why, at Professor Aswath Damodaran’s richly populated website—in particular, “Dividend Discount Models,” Chapter 13 of Damodaran on Valuation: Security Analysis for Investment and Corporate Finance (Wiley, 2d Ed. 2006):
The H model is a two-stage model for growth, but unlike the classical two-stage model, the growth rate in the initial growth phase is not constant but declines linearly over time to reach the stable growth rate in steady stage….The model is based upon the assumption that the earnings growth rate starts at a high initial rate…and declines linearly over the extraordinary growth period…to a stable growth rate….It also assumes that the dividend payout and cost of equity are constant over time and are not affected by the shifting growth rates.
The Professor (NYU Stern School of Business) addresses the limitations of the model as well as its best applications. For more of the chapter’s discussion of the H Model (p. 21) as well the Gordon Growth and Dividend Discount models, click here. Another source: Alerding also noted that an H Model summary is available in the appendix to Financial Valuation Applications and Models, by Jim Hitchner (Wiley, 2d Ed., 2006).
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