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Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition by Aswath Damodaran

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CHAPTER 22

Valuing Firms with Negative or Abnormal Earnings

In most of the valuations thus far in this book, we have looked at firms that have positive earnings. In this chapter, we consider a subset of firms with negative earnings or abnormally low earnings and examine how best to value them. We begin by looking at why firms have negative earnings in the first place and look at the ways that valuation has to be adapted to reflect these underlying reasons.

For firms with temporary problems—a strike or a product recall, for instance—we argue that the adjustment process is a simple one, where we back out of current earnings the portion of the expenses associated with the temporary problems. For cyclical firms, where the negative earnings are due to a deterioration of the overall economy, and for commodity firms, where cyclical movements in commodity prices can affect earnings, we argue for the use of normalized earnings in valuation. For firms with long-term strategic or operating problems (outdated plants, a poorly trained workforce, or poor investments in the past) the process of valuation becomes more complicated because we have to make assumptions about whether the firm will be able to outlive its problems and restructure itself. Finally, we look at firms that have negative earnings because they have borrowed too much, and consider how best to deal with the potential for default.

NEGATIVE EARNINGS: CONSEQUENCES AND CAUSES

A firm with negative earnings or abnormally low earnings ...

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