youmightwonder,aretheargumentsofferedbyproponents
of discounted cash flow valuation for not explicitly
consideringthepossibilityoffirmsfailing?Weconsiderfive
reasons often provided for this oversight. The first two
reasonsareofferedbyanalystswhobelievethatthereisno
needtoconsiderdistressexplicitly,andthelastthreereasons
by thosewho believethatdiscounted cash flowvaluations
already incorporate the effect of distress.
1.Wevalueonlylarge,publiclytradedfirms,anddistressis
veryunlikelyforthesefirms.Itistruethatthelikelihoodof
distress is lower for larger, more established firms, but
experience suggests that even these firms can become
distressed.Thelastfewmonthsof 2001 sawtheastonishing
demiseofEnron,afirmthathadamarket capitalizationin
excessof$70billionjustafewmonthspreviouslyAttheend
of2001,analystswereopenlydiscussingthepossibilitythat
large firms likeKmartand Lucent Technologies wouldbe
unabletomaketheirdebtpaymentsandmighthavetodeclare
bankruptcy. In 2006, the same talk could be heard about
GeneralMotorsandDeltaAirLines.Theotherproblemwith
thisargument,evenifweacceptthepremise,isthatsmaller,
high-growthfirms aretradedand needto bevaluedjust as
muchaslargerfirms.Infact,wecouldarguethattheneedfor
valuationisgreaterforsmallerfirms,wheretheuncertainty
and the possibility of pricing errors are greater.
- We assume that access to capital is unconstrained. In
valuation,asinmuchofcorporatefinance,weassumethata
firmwithgoodinvestmentshasaccesstocapitalmarketsand
can raise the necessary funds to meet its financing and
investmentneeds.Thus,firmswithgreatgrowthpotentialwill
neverbeforcedoutofbusinessbecausetheywillbeableto