Measuring the Risk of Financial Distress: How to Avoid the Sick Men of the Stock Market

[The] corpse is supposed to file the death certificate. Under this “honor system” of mortality, the corpse sometimes gives itself the benefit of the doubt.

—Warren Buffett, “Shareholder Letter,” 1984

From its inception in 1983 as LDDS Communications to its 1999 peak, WorldCom's stock rose from pennies per share to over $60. The WorldCom story is emblematic of the investing public's infatuation with telecommunications stocks in the dot com era. At its pinnacle, WorldCom was the United States' largest handler of Internet data,1 and a darling of Wall Street, worth almost $150 billon. In July 2002, WorldCom collapsed into bankruptcy under the ignominy of an accounting scandal. At the time, the bankruptcy filing was the largest in U.S. history, and it still remains the largest nonbank filing ever. What caused WorldCom's spectacular fall from grace, and how can we avoid stocks at risk of sustaining a permanent loss of capital?

In the aftermath of the bankruptcy filing, numerous accounting irregularities came to light, among them an improper accounting of operating expenses as capital expenses. After a torturous financial audit of the company, utilizing an army of over 500 WorldCom employees, over 200 employees of the company's outside auditor, KPMG, and a supplemental workforce of almost 600 people from Deloitte & Touche, at a total cost $365 million, WorldCom was required to make a staggering ...

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