Why does the equity of a deeply distressed company still trade above zero even when the firm's debt clearly exceeds the value of its assets?
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The answer
A share is a limited-liability claim, so its price floors at zero. The worst a shareholder can experience is losing the share's entire value, not owing money. Even when a firm's debt clearly exceeds the value of its assets, the equity still trades above zero, typically at a few cents, because it retains option value.
Equity acts like a call option on the enterprise struck at the face value of the debt: there is always some probability, however small, that the business will recover and leave something for shareholders. An option's price is never negative, so the market prices in that remote upside.
The book value of equity can turn negative, often just an accounting artifact from accumulated losses or buybacks, but the market equity value is a traded price set share by share and cannot go below zero.
Balance sheet
| Cash | 150 |
| Accounts receivable | 120 |
| Inventory | 90 |
| Total current assets | 360 |
| PP&E, net | 400 |
| Goodwill | 150 |
| Other assets | 40 |
| Total assets | 950 |
| Accounts payable | 80 |
| Deferred revenue | 40 |
| Total current liabilities | 120 |
| Long-term debt | 380 |
| Total liabilities | 500 |
| Total equity | 450 |
| Total liabilities & equity | 950 |
Also asked as
- Can a company's equity value be negative? Answer for both market equity value and book equity, and explain the economic reason for each.
- A company has a $900M market cap, $200M of debt, and $1,400M of cash. Compute its enterprise value and explain in one sentence what the market is saying about the operating business.
- Name two very different reasons a company's book equity could be negative, and explain how you'd tell from the balance sheet which one you're looking at.
- If negative enterprise value means you can buy the company for less than its net cash, why don't investors immediately arbitrage every negative-EV company? Give at least four distinct frictions.
- Your associate screens comps and includes a company at 4.2x EV/EBITDA, but its EBITDA is negative and its EV is negative. Explain precisely why the multiple is meaningless and what you would use instead.
- Why is enterprise value generally not used to value commercial banks, and what would you use instead?
- Elite: Target has market cap $2,500M; debt $800M; cash $600M of which $150M is restricted and $200M sits offshore repatriable at a 25% tax cost; a $350M unfunded pension; and a 40% equity-method stake worth $450M whose income is excluded from its $520M EBITDA. Compute the clean EV and EV/EBITDA, and identify which two adjustments a careless analyst most commonly misses.
- Elite: A biotech trades at $2.50 with 100M shares, no debt, and $480M of cash, burning $35M per quarter. An acquirer would pay a 30% premium, the process takes two quarters, wind-down costs are $25M, and there is a 40% chance of a $120M contingent liability. Compute the headline negative EV, then the expected profit from an acquire-and-liquidate strategy, and state whether the trade works.
- Elite: Using the equity-as-a-call-option framework, explain why shareholders of a distressed company might rationally prefer that management take on higher-volatility projects, why creditors oppose this, and how debt covenants respond. Then connect this to why distressed equity never trades at zero.
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The rest of this topic
Distress, bankruptcy and recoveries