How Does Bankruptcy Risk Affect Stock Values?

Abstract

Research in corporate restructuring argues that the risk of bankruptcy reduces firm value by the present value of both the direct and indirect costs of bankruptcy. Additionally, the potential for bankruptcy affects both the investment horizon of investors and the discount rate implicit in equity values. This paper empirically examines the effect of cross-sectional differences in the probability of bankruptcy on the determinants of firm value. We estimate bankruptcy probabilities for an extensive sample of more than 38,000 firm-year observations over a twelve-year period. Using a valuation model that employs both book value and earnings, we provide empirical evidence that earnings multiples decrease as the estimated probability of bankruptcy increases. These results imply that investors and analysts rely less on current earnings and more on book value (which proxies for the firm’s liquidation value) as a firm’s probability of bankruptcy increases.