- July 30, 2022
- Posted by: Ramkumar
- Category: Posts
When Equity Has Negative Value
Can equity have a negative value? The conventional wisdom says it is impossible as equity is a market cap, and share price can never fall below zero.
However, when valuing a company, we derive the value of equity as the difference between the sum of the present values of the firm’s cash flows (value of operating assets) and the firm’s net debt. In the case of heavily distressed companies, the market value of the debt diverges substantially from the book value as lenders force higher interest payments from the borrowers when they anticipate a higher default risk.
Value of equity = Value of Operating assets – net debt
When net debt > the value of operating assets, equity value becomes negative.
In such scenarios, valuing a company by conventional DCF may not be ideal as distressed companies are more likely to go bankrupt. In my view, only when the company turns around and becomes profitable will DCF valuation help. Thus, equity here takes the characteristics of an option, and investors should value it accordingly.
In Indian stock markets, we see a lot of distressed companies (penny stocks) going to #NCLT (recent case of Reliance Capital | Reliance Group). Still, the share price of such firms increases because investors expect to get liquidation proceeds and not value such companies on their turnaround potential.