Damodaran on Valuation

17.2. DISCOUNTED CASH FLOW VALUATION

Consider how we value a firm in a discounted cash flow world. We begin by projecting expected cash flows for a period, we estimate a terminal value at the end of the period that captures what we believe the firm will be worth at that point in time, and we then discount the cash flows back at a discount rate that reflects the riskiness of the firm's cash flows. This approach is an extraordinarily flexible one and can be stretched to value firms ranging from those with predictable earnings and little growth to those in high growth with negative earnings and cash flows. Implicit in this approach, though, is the assumption that a firm is a going concern, with potentially an infinite life. The terminal value is usually estimated by assuming that earnings grow at a constant rate forever (a perpetual growth rate). Even when the terminal value is estimated using a multiple of revenues or earnings, this multiple is derived by looking at publicly traded firms (usually healthy ones).

17.2.1. Distress in Discounted Cash Flow Valuation

Given the likelihood and consequences of distress, it seems foolhardy to assume that we can ignore this possibility when valuing a firm, and particularly so when we are valuing firms in poor health and with substantial debt obligations. So what, you might wonder, are the arguments offered by proponents of discounted cash flow valuation for not explicitly considering the possibility of firms failing? We consider five reasons ...