Intraditionalvaluation,weusuallyestimateexpectedvalues
foreachoftheinputvariables.Forinstance,invaluingafirm,
wemayassumeanexpectedgrowthrateinrevenuesof 30
percentayearandthattheexpectedoperatingmarginwillbe
10 percent. In reality, each of these variables has a
distributionofvalues,whichwecondenseintoanexpected
value.Simulations attemptto utilizetheinformationin the
entire distribution, rather than just the expected value, to
arrive at a value. By looking at the entire distribution,
simulationsprovideuswithanopportunitytodealexplicitly
with distress.
Beforewe beginrunning the simulations, wewill haveto
decidethecircumstancesthatwillconstitutedistressandwhat
willhappenintheeventof distress.Forexample,wemay
determinethatcumulativeoperatinglossesofmorethan$1
billionoverthreeyears willpushthefirmintodistressand
thatitwillsellitsassetsfor 25 percentofbookvalueinthat
event.Theparametersfordistresswillvarynotonly across
firms,basedontheirsizeandassetcharacteristics,butalsoon
thestateoffinancialmarketsandtheoveralleconomy.Afirm
thathasthreebadyearsinarowinahealthyeconomywith
risingequitymarketsmayhavesmallerdistresscoststhana
similar firminthemiddle ofa recession.Thestepsin the
simulation are:
Step1:Thefirststepinvolveschoosingthosevariableswhose
expectedvalueswillbereplacedbydistributions.Whilethere
may be uncertainty associated with every variable in
valuation,onlythemostcriticalvariablesmightbechosenat
this stage. For instance, revenue growth and operating
marginsmaybe thekey variables thatwechoose to build
distributions for.