Equity holders, because of their significantly higher level of risk, will ordinarily require a rate of return of at least two to two and a half times that of debt holders, depending on perceived financial and business risk. The financial risk is mostly a function of leverage, which really speaks to the residual value for stockholders after all creditors are satisfied. The lower the leverage, the more residual value there is for equity holders. The business risk reflects the probability that the company may not appropriately manage the cash drivers over the longer haul.

In almost every case, the true return actually available to equity holders is augmented beyond the nominal level of two to two and a half times the debt holder’s return. This augmentation comes via some tax advantages not available to debt holders. Longer-term capital gains get preferential tax rates; taxation on gains can be postponed at least until sale; and certain qualifying transactions involving the exchange rather than outright sale of stock may be tax-deferred.

The stockholder’s expectation of two to two and one half times the debt holder’s return translates to a 20% to 25% return for the stockholder plus some tax advantages. It is also the equivalent of paying four to five times current cash flow for the stock, before factoring in the effect of any tax advantage. If, however, there is the expectation of rapid growth in the cash flow of the firm, then the multiple of current cash flow one will pay rises even further. If the company also has a record of consistently delivering on cash-earnings expectations, there is a market premium, a slightly higher multiple as well. Investors will always pay more for growth and predictability, while they discount for stagnation or surprises.

Taken From : Cash Rules