2
Insummary,then,thepossibilityandcostsofdistressarefar
toosubstantialtobeignoredinvaluation.Thequestionthen
becomes not whether we should adjustfirm value for the
potential for distress but how best to make this adjustment.
DISCOUNTED CASH FLOW VALUATION
Consider how we value a firm in a discounted cash flow
world. We begin by projectingexpected cash flows for a
period,weestimateaterminalvalueattheendoftheperiod
thatcaptureswhatwebelievethefirmwillbeworthatthat
pointintime,andwethendiscountthecashflowsbackata
discount rate that reflects the riskiness of the firm’s cash
flows.This approachisan extraordinarily flexibleoneand
can be stretched to value firms ranging from those with
predictableearningsandlittlegrowthtothoseinhighgrowth
with negative earnings and cash flows. Implicit in this
approach,though, is theassumptionthata firmisa going
concern,withpotentiallyaninfinitelife.Theterminalvalueis
usually estimated by assuming that earnings grow at a
constantrateforever(aperpetualgrowthrate).Evenwhenthe
terminalvalueisestimatedusinga multipleofrevenuesor
earnings,thismultipleisderivedbylookingatpubliclytraded
firms (usually healthy ones).
Distress in Discounted Cash Flow Valuation
Giventhelikelihoodandconsequencesofdistress,itseems
foolhardytoassumethatwecanignorethispossibilitywhen
valuingafirm,andparticularlysowhenwearevaluingfirms
inpoorhealthandwithsubstantialdebtobligations.Sowhat,