Damodaran on Valuation

17.4. FROM FIRM TO EQUITY VALUE IN DISTRESSED FIRMS

In conventional valuation, we subtract the market value of the debt from firm value to arrive at equity value. When valuing distressed firms, we have to consider two specific issues. The first is that the shifting debt load at these firms, since these firms are often in the process of restructuring and renegotiating debt, can make identifying the dollar debt due at a point in time a hazardous exercise. The second is that equity in distressed firms may sometimes take on option characteristics and trade at a premium on what discounted cash flow valuations would suggest is the value.

17.4.1. The Shifting Debt Load

In addition to having a substantial amount of debt, distressed firms often have very complicated debt structures. Not only do they owe money to a number of different creditors, but the debt itself is usually complex—convertible, callable, and filled with special features demanded by the creditors for their own protection. In addition, distressed firms are often in the process of negotiating with debt holders, trying to convince them to change the terms of the debt and, in some cases, convert their debt into equity. Consequently, the value of the debt can change dramatically from day to day, thus affecting the value of equity, even if the enterprise value does not.

When estimating the value of debt in a distressed firm, we should consider doing the following:

• Rather than relying on the last available financial statements ...