- Firms with long-term operating, strategic, or financial
problems can have extended periods of negative or low
earnings. If we replace current earnings with normalized
earnings and value these firms, we will overvalue them.- Ifafirmseemstobeinahopelessstateandaboutto
go bankrupt, the only models that are likely to
providemeaningfulmeasuresofvaluearetheoption
pricing model (if financial leverage is high) or a
model based on liquidation value. - If, though, the firmis troubled but unlikely to go
bankrupt,wewillhavetonurseitbackto financial
health.Inpracticalterms,wewillhavetoadjustthe
operatingmarginsover timeto healthierlevelsand
value the firm based on its expected cash flows.
- Ifafirmseemstobeinahopelessstateandaboutto
2.Aninfrastructurefirmmayreportnegativeearningsinits
initial periods of growth, not because it is unhealthy but
becausetheinvestmentsithasmadetaketimetopayoff.The
cash flowsto thefirmand equity areoften also negative,
becausethecapital expenditureneedsfor thistype offirm
tendto be disproportionatelylarge relativeto depreciation.
Forthesefirmstohavevalue,capitalexpenditurehastodrop
once the infrastructure investments have been made and
operating marginshaveto improve. Thenet resultwillbe
positivecashflowsinfutureyearsandavalueforthefirm
today.
3.Youngstart-upcompanies oftenreportnegativeearnings
early in their life cycles, as they concentrate on turning
interesting ideas into commercialproducts. To value such
companies,wehavetoassumeacombinationofhighrevenue
growth and improving operating margins over time.