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Corporate Failure and Equity Valuation

An important problem for portfolio managers is how to adjust the valuation of equity for the risk that the company may fail. Traditional adjustments seem ad hoc, and previous research on the topic has ignored the irreversible nature of failure. Here, a standard equity valuation model is extended to include a parsimonious but rigorous correction for a stationary annual probability of failure. Although the correction is nonlinear, it can be reduced to an equivalent function that enters the valuation equation in the traditional additive way. Empirical benchmarking suggests that, even without assuming risk-averse investors, this approach comes closer to predicting observed equity premiums than the traditional approach. An important problem for portfolio managers is how to adjust the valuation of a company's equity for the risk that the company may fail. Traditional approaches incorporatead hoc adjustments to risk premiums in the discount rate or to the assumed average growth rate of cash flows, which are convenient in practice but possibly inaccurate. Theoretical research on the topic has typically ignored the irreversible nature of corporate failure and focused on second-moment effects (which matter only for risk-averse investors) rather than on first-moment effects (which matter even for risk-neutral investors). Furthermore, standard models typically generate predictions that are inconsistent with the historical comparison of returns between stocks and bonds. This article incorporates a stationary annual probability of corporate failure into a standard equity valuation model to provide a parsimonious but rigorous correction for failure risk. Although the correction is nonlinear, it can be reduced to an equivalent function that enters the valuation equation in the traditional additive way. Empirical benchmarking suggests that, even without assuming risk-averse investors, this approach comes closer to predicting observed equity premiums than the traditional approach. Extensions of the model provide valuation under two growth regimes with stochastic transition times. The results presented in the article can be applied either as an alternative correction for risk or as a complementary correction for risk. The model improves the results obtained by using conventional risk premiums and subjective adjustments to assumed growth rates in several ways. The model's key parameter for measuring failure risk can be calibrated in practice by using either historical business failure rates or company-specific probabilities of failure predicted by statistical models. Another use of the model would be to infer, based on the risk premium observed for a company's stock, the market's anticipated risk of failure for a given company.