Damodaran on Valuation

Chapter 17. The Cost of Distress

In both discounted cash flow (DCF) and relative valuation, we implicitly assume that the firms that we are valuing are going concerns and that any financial distress that they are exposed to is temporary. After all, a significant chunk of value in every discounted cash flow valuation comes from the terminal value, usually well in the future. But what if the distress is not temporary and there is a very real chance that the firm will not survive to get to the terminal value? In this chapter, we argue that we tend to overvalue firms such as these in traditional valuation models, largely because it is difficult to capture fully the effect of such distress in the expected cash flows and the discount rate. The degree to which traditional valuation models mis-value distressed firms will vary, depending on the care with which expected cash flows are estimated, the ease with which these firms can access external capital markets, and the consequences of distress.

We begin by looking at the underlying assumptions of discounted cash flow valuation, why DCF models do not explicitly consider the possibility of distress, and when analysts can get away with ignoring distress. We follow up by considering ways in which we can adjust discounted cash flow models to explicitly allow for the possibility of distress. In the next part of the chapter, we consider how distress is considered (or more often ignored) in relative valuation and ways of adjusting multiples for ...