The Little Book of Valuation, Updated Edition

Chapter NineDoomsday: Valuing Declining Companies

IN THE 1960S, GENERAL MOTORS (GM) was the engine that drove the US economy, but in 2009 it was a distressed company facing bankruptcy. Sears Roebuck (SHLD), a company that invented mail order retailing, has been shutting down stores over the last few years as its customers have moved to competitors. As companies age and see their markets shrink and investment opportunities dissipate, they enter the final phase of the life cycle, which is decline. While investors and analysts often avoid these firms, they may offer lucrative investment opportunities for long-term investors with strong stomachs.

Growth companies do not want to mature, and mature companies constantly try to rediscover their growth roots. By the same token, no mature company wants to go into decline, with the accompanying loss of earnings and value. So how would we differentiate between mature firms and firms in decline? Firms in decline generally have little in terms of growth potential and even their existing assets often deliver returns lower than their cost of capital; they are value destroying. The best-case scenario is for orderly decline and liquidation, and the worst case is that they go bankrupt, unable to cover debt obligations.

Declining companies tend to share common characteristics, and these shared features create problems for analysts trying to value ...