Damodaran on Valuation

17.5. CONCLUSION

Distressed firms (i.e., firms with negative earnings that are exposed to substantial likelihood of failure) present a challenge to analysts valuing them because so much of conventional valuation is built on the presumption that firms are going concerns. In this chapter, we have examined how both discounted cash flow valuation and relative valuation deal and do not deal with distress. With discounted cash flow valuation, we suggested four ways in which we can incorporate distress into value— simulations that allow for the possibility that a firm will have to be liquidated, modified discounted cash flow models where the expected cash flows and discount rates are adjusted to reflect the likelihood of default, separate valuations of the firm as a going concern and in distress, and adjusted present value models. With relative valuation, we can adjust the multiples for distress or use other distressed firms as comparable firms.

In the last part of the chapter, we examine two issues that may come up at distressed firms when going from firm value to equity value. The first relates to the shifting debt load at these firms, as the terms of debt get renegotiated and debt sometimes becomes equity. The second comes from the option characteristics exhibited by equity, especially in firms with significant financial leverage and potential for bankruptcy.