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Is Financial Distress Value Relevant? – Implications for Multiple-Based Valuation

  • Sabrina Goetz EMAIL logo
Veröffentlicht/Copyright: 18. Februar 2020

Abstract

In relative valuation peer groups of comparable companies are essential to derive the value of the firm. Valuing a target firm that is in financial distress by using a set of healthy peer group firms probably leads to an overvaluation. We examine whether the financial distress risk has an influence on a company’s value and quantify the discount through financial distress. We identify financial distress by Standard and Poor’s long-term issuer ratings and Altman’s z″-score. We then match the identified firms in financial distress with healthy counterparts that are comparable in value relevant characteristics, i. e. profitability, risk, and growth, to estimate the percentage difference in valuation multiples. Using rating information, in every year almost half of the companies are in financial distress whereas by Altman’s z″-score about 20% of the companies in the sample are in financial distress. We find that the discount caused by financial distress makes up about 4–7% of firm value. The discount increases for lower rating classes and lower z″-scores. Besides the degree of financial distress, market downturns as the financial crisis affect the distress discount.

Acknowledgements

I thank Dirk Hachmeister, Julius Tennert, Marius Burth, participants of the MBF 2018, and students of the EAFIT University and the University of Hohenheim for helpful comments and discussion. I gratefully acknowledge access to CRSP/Compustat merged database on WRDS provided by DALAHO, University of Hohenheim.

Appendix

A

1 Variable Definition of Altman’s z″-score

Table 11:

Variable definition of Altman’s z″-score.

VariableDefinition
z″-scorez′′=6.56X1+3.26X2+6.72X3+1.05X4
Liquidity ratio X1X1 = working capital/total assets
Working capital = current assets - current liabilities
Cumulative profitabilityX2X2 = retained earnings/total assets
Asset’s productivity X3X3 = earnings before interest and taxes (EBIT)/total assets
Insolvency measure X4X4 = book value of equity/book value of total liabilities
  1. This table includes the definition for Altman’s z″-score and the included variables based on Altman (2002).

2 Variable Definition for Discount

Table 12:

Variable definition for discount.

VariableDefinition
enterprise valueEVi,t=cshoi,tprcci,t+dlci,t+dltti,t+pstkrvi,tchei,t
(Loughran and Wellman 2011) with
cshoi,tprcci,t = market value (Compustat data items)
dlci,t = short-term debt (Compustat data item)
dltti,t = long-term debt (Compustat data item)
pstkrvi,t = preferred stock value (Compustat data item)
chei,t = cash and short-term investments (Compustat data item)
enterprise value for firm i in year t
EBITDA-multipleemi,t=enterprisevaluei,tEBITDAi,t; EBITDA-multiple for firm i in year t
EBIT-multipleEBITMi,t=enterprisevaluei,tEBITi,t; EBIT-multiple for firm i in year t
TobinsQTobinsQi,t=marketvalueoffirmi,ttotalassetsi,t; TobinsQ for firm i in year t
ROEROEi,t=netincomei,tbookvalueofcommonequityi.t; ROE of firm i in year t
betaβi,t; beta reported in CRSP for firm i in year t
sizesizei,t=ln(totalassetsi,t)
Cost of distressDistressDiscount=1emdistressemhealthy
  1. This table includes the definitions of the multiple calculation, the variables used in the matching procedure, and the calculation of the percentage difference in firm value.

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