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NewDistress - Valuing Distressed and Declining Companies...

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Valuing Distressed and Declining Companies Aswath Damodaran Stern School of Business [email protected] June 2009
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Valuing Distressed and Declining Companies Abstract The most difficult companies to value are at either end of the life cycle, with young growth companies and declining companies posing the biggest challenges. In this paper, we focus on companies that are at the tail end of their life cycles and examine how best to value companies with flat and declining revenues and stagnant or dropping profit margins. Since many of these companies also have significant debt burdens, we also evaluate ways to incorporate the possibility of distress and default into value. We argue that conventional discounted cash flow valuations, premised on firms being going concerns, will tend to overstate the value of distressed companies, and suggest ways in which we can correct for the bias.
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When we examine firms at the earliest stages in the life cycle, we wrestle with how best to build in the reality that most young, idea firms do not survive to become healthy business. As we move forward in the life cycle to look at growth firms, our biggest challenge became estimating growth rates, as firms became larger and competition entered the business. When we continue further up the life cycle to look at mature companies, a grouping that most growth companies seek to avoid but inevitably join, we have to evaluate the valuation consequences of acquisitions and management changes. In this paper, we will turn to the final phase of the life cycle, which is decline and examine the key questions that drive the value of firms that enter this phase. While many issues related to decline will be examined in this paper, an overriding problem that most analysts face with valuing companies in decline is a psychological one. As human beings, we are hard wired for optimism and reflect that with positive growth rates and higher cash flows in the future for the companies that we value. When valuing declining firms, we have to go against the grain and estimate cash flows for the future that may be lower than cash flows today. We will examine the process of estimating cash flows for declining firms in the first part of the paper and spend the second half looking at one possible consequence of decline, which is distress and how best to build in its likelihood into value. Declining Companies in the economy In every economy, there are companies whose best days are behind them. They tend to be clustered in a few sectors and some of these firms can be large companies that account for a significant share of economic output and employment. In the US, for instance, the automobile and steel companies, which at one time represented the heart of the economy, have been in decline for decades, but still employ large numbers and account for a significant portion of the overall economy.
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