Valuation of Financially Distressed Firms

Mads Klarskov Wøidemann & Peter Willemoes Helms

Student thesis: Master thesis


Background: Regulators are increasing their focus on improving valuations in order to increase transparency and to prevent market disruptions or large-scale failures like the 2008 crisis. When a company is in financial distress, a precise valuation is important because analysts have a tendency to rely too much on their standard approach leading to overly positive growth rates due to auto-pilot optimism. Traditional valuation techniques do not account for specific features of financially distressed companies often resulting in mispricing. Considering the limitations, this raises the question whether they are appropriate metrics for companies in financial distress. Research Focus: Based on a case study of the once dominating US retailer, Sears Holding Corporation, this thesis will assess financial distress and its implications on a valuation. Specifically, this thesis will answer the following research question: “How should a financially distressed company like Sears be valued, and is it fairly priced on 31 March 2017?”. Framework: This thesis will start by identifying the main characteristics of companies in decline, and review sources and consequences of this decline. In order to understand what leads to financial distress, this thesis will then perform a detailed review of financial distress definitions. Next, this thesis will outline the costs incurred by companies in order to fully understand the consequences associated with financial distress, before presenting the key models for assessing the severity of distress. This framework is then applied to a case company in order to assess its financial distress and the issues of valuing such a company. A performance review with an introduction of a peer group will then be performed, based on restatements of the financial statements. The performance review will then be the basis of a sales-driven forecast on a precautionary principle in order to account for the financial distress. The valuation methods will be a discounted cash flow, relative valuation and a liquidation valuation, where the financial distress is explicitly taken into account. Findings: The DCF and relative valuations indicate share prices of $16.32 and $14.25 on 31 March 2017, respectively. The values indicate that Sears was undervalued by 29.6% and 19.4% compared to the observed share price of $11.49. The liquidation valuation indicated no recovery for shareholders in a break-down scenario, emphasising the risk associated with investing in Sears. Although the pricing errors are high, the relative valuation supports the estimated DCF value, and it can therefore be concluded that Sears was undervalued by $4.83 on 31 March 2017.

EducationsMSc in Finance and Investments, (Graduate Programme) Final ThesisMSc in Finance and Accounting, (Graduate Programme) Final Thesis
Publication date2017
Number of pages194